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Causes of the Great Recession

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(Redirected from Causes of the 20072012 global financial crisis)
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Subprime mortgage crisis
Major dimensions[show]

Causes[show]

Summits[show]

Legislation and spending[show]

Company bailouts[show]

v
t
e
Many factors directly and indirectly caused the Great Recession (which started with the US
subprime mortgage crisis), with experts placing different weights upon particular causes.
The crisis resulted from a combination of complex factors, including easy credit conditions
during the 20022008 period that encouraged high-risk lending and borrowing practices without
assessing default-risk; international trade imbalances; real-estate bubbles that have since burst;
fiscal policy choices related to government revenues and expenses; and approaches used by
nations to bail out troubled banking industries and private bondholders, assuming private debt
burdens or socializing losses.
[1][2]

One narrative describing the causes of the crisis begins with the significant increase in savings
available for investment during the 20002007 period when the global pool of fixed-income
securities increased from approximately $36 trillion in 2000 to $80 trillion by 2007. This "Giant
Pool of Money" increased as savings from high-growth developing nations entered global capital
markets. Investors searching for higher yields than those offered by U.S. Treasury bonds sought
alternatives globally.
[3]

The temptation offered by such readily available savings overwhelmed the policy and regulatory
control mechanisms in country after country, as lenders and borrowers put these savings to use,
generating bubble after bubble across the globe. While these bubbles have burst, causing asset
prices (e.g., housing and commercial property) to decline, the liabilities owed to global investors
remain at full price, generating questions regarding the solvency of consumers, governments and
banking systems.
[2]

Struggling banks in the U.S. and Europe cut back lending causing a credit crunch. Consumers
and some governments were no longer able to borrow and spend at pre-crisis levels. Businesses
also cut back their investments as demand faltered and reduced their workforces. Higher
unemployment due to the recession made it more difficult for consumers and countries to honor
their obligations. This caused financial institution losses to surge, deepening the credit crunch,
thereby creating an adverse feedback loop.
[4]

The U.S. Financial Crisis Inquiry Commission reported its findings in January 2011. It
concluded that "the crisis was avoidable and was caused by: Widespread failures in financial
regulation, including the Federal Reserves failure to stem the tide of toxic mortgages; Dramatic
breakdowns in corporate governance including too many financial firms acting recklessly and
taking on too much risk; An explosive mix of excessive borrowing and risk by households and
Wall Street that put the financial system on a collision course with crisis; Key policy makers ill
prepared for the crisis, lacking a full understanding of the financial system they oversaw; and
systemic breaches in accountability and ethics at all levels.
[5][6]

Contents
[hide]



Who's Who of Wall Street . Who Predicted the Financial
Crisis . News . Resources . About Us


Who is to Blame for the
Financial Crisis

Research Questions:
Who contributed to the
creation of the financial
crisis and ensuing economic
crisis?
Who is to blame for the
financial crisis?
Can they be held
responsible for their actions
or inactions?
Was there a conspiracy by
some Wall Street executives
and government officials?
Do investors have legal
cause to seek
compensation for damages
caused by Wall Street
firms?

Research Findings:
Who contributed to the creation to
the financial crisis and the ensuing
economic crisis?
The following is a general answer
followed by a section naming the
key players:
Regulators who relaxed
risk management
regulations required by the
banks and for not regulating
derivative investments
(please, see more specific
details below)
The Federal Reserve
Chairmen who dismissed
the build-up of the housing
bubble from 2002 to 2007
until it was too late. They did
not take actions to regulate


Economic
predictions from
the world's top
experts on the
financial crisis

Dean Baker's
Predictions


Med Jones
Predictions


Nouriel Roubini's
Predictions
mortgage companies or
control the housing bubble
World Central
Bankers who blindly
copied the US Federal
Reserve Bank policies
World Financial
Regulators who blindly
copied US financial market
models and regulations
World Investment Banks
who sold subprime (high
risk) mortgage backed
securities to their customers
without fully understanding
them and who hired credit
rating agencies to rate them
as high quality investment
when in fact they included
high risk loans. The same
banks who sold the
subprime investments later
bet against their own clients
without disclosing the
conflict of interest to their
clients
Credit Rating Agencies
who overrated junk
securities as investment-
grade quality and misled
investors about the risk and
the value of these
investments
Academic and Financial
Economists who ignored
the warnings and misjudged
macroeconomic and
financial market indicators
Award-winning
Economists who designed
flawed risk pricing models
Investment Analysts who
used flawed risk pricing
models and asset portfolio
theories
Wall Street Banking
Executives who ignored
internal risk management
policies out of greed to
increase revenues and their
bonuses in the short term at
the expense of long term
stability of their companies
Wall Street Boards of
Directors who did not

Peter Schiff's
Predictions

The Rise & Fall of
Financial Assets

Knowledge
@
Wharton
University

Wall Street
Economic
&
Financial
Research

London
protect their shareholders
against excessive executive
compensation and ignored
prudent risk management
strategies
Wall Street Advisors who
did not do their homework
before advising their clients
on bad investments
Investment Fund
Managers who lost billions
of dollars investing without
adequate due diligence
Mortgage Brokers who
sold loans to unqualified
borrowers in order to collect
more commissions
Homebuyers who took
loans they could not afford
to pay back and blamed the
banks for predatory lending
US Presidents for hiring
former Wall Street lobbyists
as government policy
makers who bailed out the
banks without regard to the
moral hazard. By doing so,
they shifted the burden on
the taxpayers and risked the
future of the national
economy
US Supreme Court
Justices who ruled that the
government may not ban
political spending by
corporations in candidate
elections thus tightening the
grip of Wall Street on
government officials and
skewing the balance of
power in favor of Wall Street
and big companies.
The Financial Media who
took no responsibility for
promoting the illusions of a
healthy housing sector and
for not asking the right
questions. Media outlets
that favored a promotional
business model at the
expense of investigative
journalism. In our research,
we found a prevalent bias in
allocating airwaves and print
space to brand name
School of
Economics
Financial
Journalism Ethics

City
University
London
Challenges of
Financial
Journalism

experts. Most journalists
and editors seem to ignore
voices that are not well-
known or those who have a
story that do not fit their
narrative or preconception.
All we had to do is Google
simple phrases like "US
Economic Risks" to find a
wealth of information that
would raise so many critical
questions. If equal media
exposure was given to the
voices that warned us about
the housing bubble, the
damage could have been
mitigated.
We also recommend reading three
interesting articles about the subject
on FactCheck.Org , TIME magazine
and US News Report

Who are the key people and
companies to blame for the
financial crisis?
The blame is shared between a Wall
Street Cabal and some government
officials who unwittingly or knowingly
executed the Cabal's agenda and
continue to empower them and
protect them.
The Wall Street Cabal dominates
the US government, treasury,
congress, and federal reserve banks
through their lobbying arm the
Financial Services Roundtable
(www.fsround.org) The cabal consist
of the largest investment banks and
financial conglomerates, including
Goldman Sachs, Morgan Stanley,
Merrill Lynch, Lehman Brothers,
Bear Stearns, Citibank and JP
Morgan. Securities insurance
companies like AIG, MBIA, AMBAC
and the top three credit rating
agencies including Moody's,
Standard & Poor's and Fitch.
Their partners were prominent
academics and ex-Wall Street
executives who worked for the
government and protected their
agenda. These people were
appointed by US Presidents
including Reagan, Bush Senior,
Clinton, Bush and Obama to top
government positions, in part as a
payback for campaign contribution
by some of these Wall Street firms.
Some of these government officials
unwittingly empowered the cabal
and some took deliberate actions to
bailout Wall Street and later
protected them from prosecution.
The complex Wall Street fraud
scheme and the key players
behind the financial crisis
Home, car and other loans were
packaged by top Wall Street
investment banks (like Goldman
Sachs, Morgan Stanley, Merrill
Lynch and others) and called them
CDOs (Collateralized Debt
Obligations) then was sold to
investors. These types of
investments are called derivative
securities.
These investment banks paid the
supposedly "independent" rating
agencies (Moody's, S&P and Fitch)
to rate CDOs as high-
grade investments when in fact
many of them included high risk
mortgage loans (called subprime).
This is a clear conflict of interest by
the rating agencies and a suspected
effort by banks to defraud their
clients to get more money for these
CDOs. After the CDOs received A-
ratings, they created the impression
that they are secure investments.
These CDOs, then became popular
with investors and many retirement
funds that held the life savings of
millions of people who bought them.
To make things worse, large
insurance companies like AIG sold
insurance for investors who bought
CDOs to protect against potential
losses (in case some borrowers did
not pay their loans). AIG called
these types of insurance policies
Credit Default Swaps (CDS) making
them even more popular with global
investors and reinforcing the illusion
that their investments is highly
secure and if they fail they will be
covered by the insurance policies.
What is unusual is that AIG allowed
other investors to buy insurance on
CDOs that they do not even own. So
an investor can pay small insurance
fee for a CDO that someone else
owns. If that CDO investment went
bad, the investors who paid the
insurance (can be the actual owners
and others) would collect the full
value of that CDO.
This allowed few investors who
knew that these investment were
bad to buy insurance as a bet
against the failure of the
CDOs. John Paulson is one of the
investors who knew that these
CDOs were bad, so he bought the
insurance betting that they will fail.
He made $12B betting against
mortgage securities. When he ran
out of CDO investments, he worked
with Goldman Sachs and Deutsche
Bank to create more of them so he
can bet against them. Goldman
Sachs that sold CDOs to investors,
later bet against CDO type
investments that they sold to their
clients without disclosing the conflict
of interest. Other Hedge Funds like
Tricadia and Magnetar, made
billions betting against CDOs they
designed with Merrill Lynch, JP
Morgan and Lehman
Brothers. (Source: Inside Job
Documentary)
Thanks to Wall Street Cabal, their
lobbyists, hired senators, and
people inside the government (see
list of names below), who opposed
the regulations of Wall Street, AIG
did not need to have money to cover
the losses by the CDOs if the
borrowers did not pay their
loans. They also did not prosecute
the credit rating agencies who mis-
rated the CDOs. The defense of
Wall Street executives is that the
markets are not regulated and they
were the ones who pushed for
deregulations in the first place.
It seems to us, even if the markets
are not regulated, the common law
punishes fraud activities and
misleading clients by knowingly
selling bad securities and loans to
clients without disclosing the risks.
They misled clients by having them
believe they are high quality
investments where in fact they were
junk-rated investments.
Some key regulators, policy makers,
and influencers in the government
are former Wall Street executives
and lobbyists who have strong ties
to the investment banks and who
later got compensated generously
by Wall Street firms, thus raising
serious question about a conflict of
interest in their decisions and
policies.
The US government ended up
paying taxpayers money to bailout
the Wall Street Cabal. Henry
Paulson the former Treasury
Secretary was the CEO of Goldman
Sachs and during his tenure sold
many of the subprime investments.
He was one of the main architects of
Wall Street bailout. He bailed out the
banks and later AIG on the condition
not to sue Goldman Sachs or other
companies involved in CDOs.

Key government officials to
blame (A partial list)
Martin Fieldstien, a Harvard
Professor and former Chief
Economic Advisor who championed
the deregulation initiatives of the
financial markets during Regan's
Administration and later severed on
the board of AIG and AIG financial
products that insured CDOs. - A key
player causing the global financial
crisis.
Alan Greenspan who championed
Savings and Loans deregulations
allowing these banks to speculate
with consumer deposit. Alan
Greenspan refused to regulate the
mortgage industry, despite several
warnings and allowed the formation
of housing bubble during his tenure
as Federal Reserve Chairman. Alan
Greenspan was later hired by John
Paulson who made billions betting
on subprime mortgages that he
refused to regulate. (Source: New
York Magazine)
Larry Summers and Robert Rubin,
former Treasury Secretaries (Rubin
is also a former CEO of Goldman
Sachs) championed Gramm
LeachBliley (GLB) Act, effectively
repealing GlassSteagall Act, thus
allowing the mergers of consumer
banks with investment banks
furthering the risk of speculation of
with people's money. Larry summers
later made $20M as a consultant for
banks and funds that sold
derivatives (Source: Panderer to
Power: The Untold Story of How
Alan Greenspan Enriched Wall
Street and Left a Legacy of
Recession - By Frederick J.
Sheehan)
In 2000 Senator Phil Gramm, Alan
Greenspan, Robert Rubin and
Arthur Levitt (former SEC
Chairman) lobbied against an effort
to regulate the derivative markets
that later turned to be at the heart of
the crisis. After leading the senate
effort to prevent the regulation of
derivatives, Phil Gramm became the
Vice Chairman of UBS and Rubin
Became the Vice Chairman of
Citibank earning more than $127
million (Source: SourceWatch)
Senator Phil's wife Wendy Gramm
served on the board of Enron -
infamous for its fraud and
collapse (Source: Alternet)
Current and former Federal Reserve
Board members including Ben
Bernanke, Donald Kophn, Kevin
Warsh, Randall Krozner, Frederic
Mishkin, Janet L. Yellen, Elizabeth
A. Duke, Daniel K. Tarullo, and
Sarah Bloom Raskin. In July 2005
in an Interview with Maria
Bartiromo, Federal Reserve
Chairman denied there is a housing
bubble and its impact on the
economy, saying "It is pretty unlikely
possibility, we never had a decline in
housing prices on a nation wide
basis" In Feb of 2006, he became
the Federal Reserve Chairman and
despite several later warning he did
nothing to control the housing
bubble (Source: CNBC Interview.
Transcript at Freedom Works).
In 2004 Henry Paulson who is
during his tenure as the CEO of
Goldman Sachs was the highest
paid CEO on Wall Street and sold
most numbers of subprime
mortgages (part of the CDOs), later
he was appointed by President
George W Bush as the Treasury
Secretary and helped in bailing out
the banks, including Goldman Sachs
- his former employer. He also
helped lobby the Security and
Exchange Commission to relax
limits on banking leverage, allowing
banks to loan more money in ratio to
actual deposits. The leverage ration
became 40-1. That is for every 1
dollar they had in their banks, they
could make loans up to 40 dollars.
This resulted in the creation of the
banking debt crisis and housing
bubble. Goldman Sachs that sold
CDOs to investors, later bet against
CDO type investments, that they
sold to their investors. Henry
Paulson bailed out AIG on the
condition not to sue Goldman Sachs
or other companies involved in
CDOs.
(Sources: Documentaries Breaking
The Bank, Inside the Meltdown, Bill
Moyers Journal, 60 Minutes Wall
Street Shadow Markets and Inside
Job )

Research Comments:
Can investors trust Wall Street
investment advice? Can they be
trusted with their money and
lifesavings? You be the judge.
Can US politicians including
senators, regulators, and economic
advisors be trusted with protecting
the citizens and the US economy?
The lack of protection against
conflict of interest in policy making,
the incompetence of most
economists and regulators and the
consorted efforts by few Wall Street
insiders allowed this fraudulent CDO
investment scheme to crash the US
and global financial markets. If the
Wall Street cabal is not held
accountable for their actions, they
will lead to the collapse of the US
economy.
According to Med Jones, the
president of International Institute of
Management, "Despite all the
events that led to the economic
crisis of 2008 and 2009, last year
(2010), the US Supreme Court ruled
that the government cannot limit
financial contributions of
corporations to the election
campaigns of political candidates.
This decision will enforce special
interest groups and Wall Street's
grip on the government. This
imbalance of power will likely allow a
few powerful groups to bring the US
economy down in a series of
financial, economic and political
crises. Throughout history, every
empire was disintegrated from
inside first by similar abuses of
power structures. The US is not
immune to socioeconomic laws"

Was there a conspiracy by some
Wall Street executives and
government officials? Can they
be held responsible for their
actions or inactions? Do
investors have legal cause to
seek compensation for damages
caused by Wall Street firms?
To answer these question, we have
to list the legal definition of the
activities that appear to be illegal
Definition of Torts
Tort is the French word for wrong.
The legal definition of Tort is an act
that injures someone in some way,
and for which the injured person
may sue the wrongdoer for
damages. Legally, torts are called
civil wrongs. A tort can be negligent
or intentional civil wrong.
Tort law imposes a duty on persons
and business agents not to
intentionally or negligently injure
others in society.
Under tort law, an injured party can
bring a civil lawsuit to seek
monetary compensation for a wrong
done to the party or the partys
property from the offending party.
Negligence is a 'legal cause' of
damage if it directly and in natural
and continuous sequence produces
or contributes substantially to
producing such damage, so it can
reasonably be said that if not for the
negligence, the loss, injury or
damage would not have occurred.
For example, Negligent
Mismanagement arises when the
injury suffered by the tort victim
(such as investors who lost money)
can be attributed to carelessness in
the oversight of some aspect of the
corporation's operations. It relates to
situations where the board of
directors knew of, or ought to have
foreseen, a systemic problem and
failed to address it.
Directors who breach any of their
duties to the corporation and their
shareholders may be liable if the
corporation suffers a loss that can
be directly attributed to their actions
or omissions. To protect themselves
from such liability, directors should
always consider whether the
decisions or actions being taken are
in the best interests of the
corporation. They must discharge
their duties of skill and diligence, as
well their duty of loyalty, including
acting honestly and in good faith,
not improperly delegating their
responsibilities, and avoiding
conflicts of interest
Definition of Crimes
Crime is any act done by an
individual in violation of those duties
that he or she owes to society and
for the breach of the law, the
wrongdoer shall make amends to
the public.
Inchoate (inko-wet) crimes are
incomplete crimes and crimes
committed by non-participants such
as criminal conspiracy, attempt to
commit a crime, and aiding and
abetting the commission of a crime.
Fraud is considered a crime.
The legal definition of Fraud:
Fraud is generally defined in the law
as an intentional misrepresentation
of material existing fact made by
one person to another with
knowledge of its falsity and for the
purpose of inducing the other
person to act, and upon which the
other person relies with resulting
injury or damage. Fraud may also
be made by an omission or
purposeful failure to state material
facts, which nondisclosure makes
other statements misleading.
For example, if a business or a
person knowingly rate an investment
as high quality when in fact they
knew it is not, that person is
committing criminal fraud. Even if
someone did not sell the investment
but knowingly aided in the
commission of the crime. That
person is also criminally liable.

Research Conclusions:
Our research did not find evidence
of conspiracy in designing the
financial crisis. This does not mean
that there was no conspiracy. Such
determination requires substantial
investigative resources that we do
not have.
However, our research found
several actions and decisions by top
government officials and Wall Street
executives that may fall under the
definition of torts or crimes. Whether
in fact there are crimes committed or
not, we will leave that determination
to the justice system.
It is in our opinion that most of the
people who contributed to the
financial crisis were simply
incompetent or driven by a blind
belief in the ideology of free
markets. However, few people
standout and appear to have acted
intentionally and with total disregard
to risk management and their
fiduciary duties to protect their
clients, investors and other
stakeholders. Whether there is a
legal cause to sue them or not we
will leave that to the American
public, attorneys and the investors
who lost their lifesavings.
As for the the impact of the
subprime and housing bubble on the
economy, we can honestly say very
few experts properly estimated the
impact of certain government
policies on the economy. Also, we
believe very few economists knew
the inner workings of the financial
investments that was sold on Wall
Street.
Can Wall Street activities can be
considered criminal. You be the
judge. If you have some additional
information, please email us at
research {at}
economicpredictions.org

Other research questions and
findings:
1. Why did the world's top
economists fail to predict
the financial crisis? (Others
who missed the crisis,
include government leaders,
award-winning scientists,
market analysts and
investors). Was the crisis
predictable or was it a Black
Swan (unpredictable)
event? Are government
policy makers competent
enough to manage the
nation's financial freedom
and security? Are
economists and their
policies helping or hurting
our economic growth? Do
we need to re-define the
education of economic
science and the role that
economists play in our
financial markets,
government policies and
business regulations?
2. Who is to blame for the
financial crisis? Who
contributed to the creation
of the crisis? Can they be
held responsible for their
actions or inactions? Was
there a conspiracy by some
Wall Street executives and
government officials? Do
investors have legal cause
to seek compensation for
damages caused by Wall
Street firms?
3. Who predicted the financial
crisis and the ensuing
economic crisis? Is there a
documented evidence
supporting their claims?
Were those who warned
about the crisis lucky or did
they have a clear logic
behind their predictions?
Can we use their knowledge
to predict future crises?
What are their future
predictions? How do their
predictions compare with
each other? Where do the
experts agree and where do
they disagree? How
accurate are their economic
predictions? Can they be
relied on for investment
decisions?
4. Who are the top winners
and losers of the financial
crisis? Top investors,
economists, intellectuals,
government officials, think
tanks, and universities that
lost or won because of the
crisis.
5. What are the lessons we
can learn to avoid future
crises? What the the
economic policy lessons?
What are the investor's
lessons? Do we need more
or less financial regulations?


Economic Predictions from Top Wall Street
Economists
(C) Economic Predictions
Research Project


From Wikipedia, the free encyclopedia
(Redirected from Causes of the 20072012 global financial crisis)
Jump to: navigation, search
Subprime mortgage crisis
Major dimensions[show]

Causes[show]

Summits[show]

Legislation and spending[show]

Company bailouts[show]

v
t
e
Many factors directly and indirectly caused the Great Recession (which started with the US
subprime mortgage crisis), with experts placing different weights upon particular causes.
The crisis resulted from a combination of complex factors, including easy credit conditions
during the 20022008 period that encouraged high-risk lending and borrowing practices without
assessing default-risk; international trade imbalances; real-estate bubbles that have since burst;
fiscal policy choices related to government revenues and expenses; and approaches used by
nations to bail out troubled banking industries and private bondholders, assuming private debt
burdens or socializing losses.
[1][2]

One narrative describing the causes of the crisis begins with the significant increase in savings
available for investment during the 20002007 period when the global pool of fixed-income
securities increased from approximately $36 trillion in 2000 to $80 trillion by 2007. This "Giant
Pool of Money" increased as savings from high-growth developing nations entered global capital
markets. Investors searching for higher yields than those offered by U.S. Treasury bonds sought
alternatives globally.
[3]

The temptation offered by such readily available savings overwhelmed the policy and regulatory
control mechanisms in country after country, as lenders and borrowers put these savings to use,
generating bubble after bubble across the globe. While these bubbles have burst, causing asset
prices (e.g., housing and commercial property) to decline, the liabilities owed to global investors
remain at full price, generating questions regarding the solvency of consumers, governments and
banking systems.
[2]

Struggling banks in the U.S. and Europe cut back lending causing a credit crunch. Consumers
and some governments were no longer able to borrow and spend at pre-crisis levels. Businesses
also cut back their investments as demand faltered and reduced their workforces. Higher
unemployment due to the recession made it more difficult for consumers and countries to honor
their obligations. This caused financial institution losses to surge, deepening the credit crunch,
thereby creating an adverse feedback loop.
[4]

The U.S. Financial Crisis Inquiry Commission reported its findings in January 2011. It
concluded that "the crisis was avoidable and was caused by: Widespread failures in financial
regulation, including the Federal Reserves failure to stem the tide of toxic mortgages; Dramatic
breakdowns in corporate governance including too many financial firms acting recklessly and
taking on too much risk; An explosive mix of excessive borrowing and risk by households and
Wall Street that put the financial system on a collision course with crisis; Key policy makers ill
prepared for the crisis, lacking a full understanding of the financial system they oversaw; and
systemic breaches in accountability and ethics at all levels.
[5][6]

Contents
[hide]
1 Overview
2 Housing market
o 2.1 The U.S. housing bubble and foreclosures
o 2.2 Subprime lending
2.2.1 Mortgage underwriting
2.2.2 Mortgage fraud
2.2.3 Down payments and negative equity
2.2.4 Predatory lending
3 Risk-taking behavior
o 3.1 Consumer and household borrowing
4 Excessive private debt levels
o 4.1 Home equity extraction
o 4.2 Housing speculation
o 4.3 Pro-cyclical human nature
o 4.4 Corporate risk-taking and leverage
4.4.1 Net capital rule
4.4.2 Perverse incentives
4.4.3 Political Corruption
5 Financial market factors
o 5.1 Financial product innovation
o 5.2 Inaccurate credit ratings
o 5.3 Lack of transparency and independence in financial modeling
o 5.4 Off-balance-sheet financing
o 5.5 Regulatory avoidance
o 5.6 Financial sector concentration
6 Governmental policies
o 6.1 Failure to regulate non-depository banking
o 6.2 Affordable housing policies
o 6.3 Government deregulation as a cause
7 Macroeconomic conditions
o 7.1 Interest rates
o 7.2 Globalization and Trade deficits
o 7.3 Chinese mercantilism
o 7.4 End of a long wave
o 7.5 Paradoxes of thrift and deleveraging
8 Capital market pressures
o 8.1 Private capital and the search for yield
9 Boom and collapse of the shadow banking system
o 9.1 Significance of the parallel banking system
o 9.2 Run on the shadow banking system
10 Mortgage compensation model, executive pay and bonuses
11 Regulation and Deregulation
12 Conflicts of interest and lobbying
13 Other factors
o 13.1 Commodity price volatility
o 13.2 Inaccurate economic forecasting
o 13.3 Monetary expansion and uncertainty
o 13.4 Over-leveraging, credit default swaps and collateralized debt obligations as causes
o 13.5 Credit creation as a cause
o 13.6 Oil prices
o 13.7 Emigration
o 13.8 Overproduction
14 References
15 Books
16 External links
Overview[edit]


Housing price appreciation in selected countries, 2002-2008
The immediate or proximate cause of the crisis in 2008 was the failure or risk of failure at major
financial institutions globally, starting with the rescue of investment bank Bear Stearns in March
2008 and the failure of Lehman Brothers in September 2008. Many of these institutions had
invested in risky securities that lost much or all of their value when U.S. and European housing
bubbles began to deflate during the 2007-2009 period, depending on the country. Further, many
institutions had become dependent on short-term (overnight) funding markets subject to
disruption.
[7][8]

The origin of these housing bubbles involves two major factors: 1) Low interest rates in the U.S.
and Europe following the 2000-2001 U.S. recession; and 2) Significant growth in savings
available from developing nations due to ongoing trade imbalances.
[9]
These factors drove a large
increase in demand for high-yield investments. Large investment banks connected the housing
markets to this large supply of savings via innovative new securities, fueling housing bubbles in
the U.S. and Europe.
[10]

Many institutions lowered credit standards to continue feeding the global demand for mortgage
securities, generating huge profits which its investors shared. They also shared the risk. When
the bubbles developed, household debt levels rose sharply after the year 2000 globally.
Households became dependent on being able to refinance their mortgages. Further, U.S.
households often had adjustable rate mortgages, which had lower initial interest rates and
payments that later rose. When global credit markets essentially stopped funding mortgage-
related investments in the 2007-2008 period, U.S. homeowners were no longer able to refinance
and defaulted in record numbers, leading to the collapse of securities backed by these mortgages
that now pervaded the system.
[10][11]

The failure rates of subprime mortgages were the first symptom of a credit boom tuned to bust
and of a real estate shock. But large default rates on subprime mortgages cannot account for the
severity of the crisis. Rather, low-quality mortgages acted as an accelerant to the fire that spread
through the entire financial system. The latter had become fragile as a result of several factors
that are unique to this crisis: the transfer of assets from the balance sheets of banks to the
markets, the creation of complex and opaque assets, the failure of ratings agencies to properly
assess the risk of such assets, and the application of fair value accounting. To these novel factors,
one must add the now standard failure of regulators and supervisors in spotting and correcting
the emerging weaknesses.
[12]

Federal Reserve Chair Ben Bernanke testified in September 2010 regarding the causes of the
crisis. He wrote that there were shocks or triggers (i.e., particular events that touched off the
crisis) and vulnerabilities (i.e., structural weaknesses in the financial system, regulation and
supervision) that amplified the shocks. Examples of triggers included: losses on subprime
mortgage securities that began in 2007 and a run on the shadow banking system that began in
mid-2007, which adversely affected the functioning of money markets. Examples of
vulnerabilities in the private sector included: financial institution dependence on unstable
sources of short-term funding such as repurchase agreements or Repos; deficiencies in corporate
risk management; excessive use of leverage (borrowing to invest); and inappropriate usage of
derivatives as a tool for taking excessive risks. Examples of vulnerabilities in the public sector
included: statutory gaps and conflicts between regulators; ineffective use of regulatory authority;
and ineffective crisis management capabilities. Bernanke also discussed "Too big to fail"
institutions, monetary policy, and trade deficits.
[13]

The majority report of the U.S. Financial Crisis Inquiry Commission (supported by 6 Democrat
appointees without Republican participation) reported its findings in January 2011. It concluded
that "the crisis was avoidable and was caused by: Widespread failures in financial regulation,
including the Federal Reserves failure to stem the tide of toxic mortgages; Dramatic
breakdowns in corporate governance including too many financial firms acting recklessly and
taking on too much risk; An explosive mix of excessive borrowing and risk by households and
Wall Street that put the financial system on a collision course with crisis; Key policy makers ill
prepared for the crisis, lacking a full understanding of the financial system they oversaw; and
systemic breaches in accountability and ethics at all levels.
[14]

Housing market[edit]
The U.S. housing bubble and foreclosures[edit]
Main article: United States housing bubble


Number of U.S. residential properties subject to foreclosure actions by quarter (2007-2009).
Between 1997 and 2006, the price of the typical American house increased by 124%.
[15]
During
the two decades ending in 2001, the national median home price ranged from 2.9 to 3.1 times
median household income. This ratio rose to 4.0 in 2004, and 4.6 in 2006.
[16]
This housing
bubble resulted in quite a few homeowners refinancing their homes at lower interest rates, or
financing consumer spending by taking out second mortgages secured by the price appreciation.
By September 2008, average U.S. housing prices had declined by over 20% from their mid-2006
peak.
[17][18]
Easy credit, and a belief that house prices would continue to appreciate, had
encouraged many subprime borrowers to obtain adjustable-rate mortgages. These mortgages
enticed borrowers with a below market interest rate for some predetermined period, followed by
market interest rates for the remainder of the mortgage's term. Borrowers who could not make
the higher payments once the initial grace period ended would try to refinance their mortgages.
Refinancing became more difficult, once house prices began to decline in many parts of the
USA. Borrowers who found themselves unable to escape higher monthly payments by
refinancing began to default. During 2007, lenders had begun foreclosure proceedings on nearly
1.3 million properties, a 79% increase over 2006.
[19]
This increased to 2.3 million in 2008, an
81% increase vs. 2007.
[20]
As of August 2008, 9.2% of all mortgages outstanding were either
delinquent or in foreclosure.
[21]

The Economist described the issue this way: "No part of the financial crisis has received so much
attention, with so little to show for it, as the tidal wave of home foreclosures sweeping over
America. Government programmes have been ineffectual, and private efforts not much better."
Up to 9 million homes may enter foreclosure over the 2009-2011 period, versus one million in a
typical year.
[22]
At roughly U.S. $50,000 per foreclosure according to a 2006 study by the
Chicago Federal Reserve Bank, 9 million foreclosures represents $450 billion in losses.
[23]

Subprime lending[edit]


U.S. Subprime lending expanded dramatically 2004-2006
Further information: Sub-prime mortgage crisis


GAO Historical Data
Based on the assumption that sub-prime lending precipitated the crisis, some
[who?]
have argued
that the Clinton Administration may be partially to blame. This GAO chart demonstrates that
sub-prime and Alt-A loans peaked after 2003.
[citation needed]

In addition to easy credit conditions, there is evidence that both competitive pressures and some
government regulations contributed to an increase in the amount of subprime lending during the
years preceding the crisis. Major U.S. investment banks and, to a lesser extent, government-
sponsored enterprises like Fannie Mae played an important role in the expansion of higher-risk
lending.
[24][25][26]

The term subprime refers to the credit quality of particular borrowers, who have weakened credit
histories and a greater risk of loan default than prime borrowers.
[27]
The value of U.S. subprime
mortgages was estimated at $1.3 trillion as of March 2007,
[28]
with over 7.5 million first-lien
subprime mortgages outstanding.
[29]

Subprime mortgages remained below 10% of all mortgage originations until 2004, when they
spiked to nearly 20% and remained there through the 2005-2006 peak of the United States
housing bubble.
[30]
A proximate event to this increase was the April 2004 decision by the U.S.
Securities and Exchange Commission (SEC) to relax the net capital rule, which encouraged the
largest five investment banks to dramatically increase their financial leverage and aggressively
expand their issuance of mortgage-backed securities.
[31]
Subprime mortgage payment
delinquency rates remained in the 10-15% range from 1998 to 2006,
[32]
then began to increase
rapidly, rising to 25% by early 2008.
[33][34]

Mortgage underwriting[edit]
In addition to considering higher-risk borrowers, lenders offered increasingly risky loan options
and borrowing incentives. Mortgage underwriting standards declined gradually during the boom
period, particularly from 2004 to 2007.
[35]
The use of automated loan approvals allowed loans to
be made without appropriate review and documentation.
[36]
In 2007, 40% of all subprime loans
resulted from automated underwriting.
[37][38]
The chairman of the Mortgage Bankers Association
claimed that mortgage brokers, while profiting from the home loan boom, did not do enough to
examine whether borrowers could repay.
[39]
Mortgage fraud by lenders and borrowers increased
enormously.
[40]

A study by analysts at the Federal Reserve Bank of Cleveland found that the average difference
between subprime and prime mortgage interest rates (the "subprime markup") declined
significantly between 2001 and 2007. The quality of loans originated also worsened gradually
during that period. The combination of declining risk premia and credit standards is common to
boom and bust credit cycles. The authors also concluded that the decline in underwriting
standards did not directly trigger the crisis, because the gradual changes in standards did not
statistically account for the large difference in default rates for subprime mortgages issued
between 2001-2005 (which had a 10% default rate within one year of origination) and 2006-2007
(which had a 20% rate). In other words, standards gradually declined but defaults suddenly
jumped. Furthermore, the authors argued that the trend in worsening loan quality was harder to
detect with rising housing prices, as more refinancing options were available, keeping the default
rate lower.
[41][42]

Mortgage fraud[edit]
In 2004, the Federal Bureau of Investigation warned of an "epidemic" in mortgage fraud, an
important credit risk of non-prime mortgage lending, which, they said, could lead to "a problem
that could have as much impact as the S&L crisis".
[43][44][45][46]

Down payments and negative equity[edit]
A down payment refers to the cash paid to the lender for the home and represents the initial
homeowners' equity or financial interest in the home. A low down payment means that a home
represents a highly leveraged investment for the homeowner, with little equity relative to debt. In
such circumstances, only small declines in the value of the home result in negative equity, a
situation in which the value of the home is less than the mortgage amount owed. In 2005, the
median down payment for first-time home buyers was 2%, with 43% of those buyers making no
down payment whatsoever.
[47]
By comparison, China has down payment requirements that
exceed 20%, with higher amounts for non-primary residences.
[48]

Economist Nouriel Roubini wrote in Forbes in July 2009 that: "Home prices have already fallen
from their peak by about 30%. Based on my analysis, they are going to fall by at least 40% from
their peak, and more likely 45%, before they bottom out. They are still falling at an annualized
rate of over 18%. That fall of at least 40%-45% percent of home prices from their peak is going
to imply that about half of all households that have a mortgageabout 25 million of the 51
million that have mortgagesare going to be underwater with negative equity and will have a
significant incentive to walk away from their homes."
[49]

Economist Stan Leibowitz argued in the Wall Street Journal that the extent of equity in the home
was the key factor in foreclosure, rather than the type of loan, credit worthiness of the borrower,
or ability to pay. Although only 12% of homes had negative equity (meaning the property was
worth less than the mortgage obligation), they comprised 47% of foreclosures during the second
half of 2008. Homeowners with negative equity have less financial incentive to stay in the
home.
[50]

The L.A. Times reported the results of a study that found homeowners with high credit scores at
the time of entering a mortgage are 50% more likely to "strategically default" - abruptly and
intentionally pull the plug and abandon the mortgage compared with lower-scoring
borrowers. Such strategic defaults were heavily concentrated in markets with the highest price
declines. An estimated 588,000 strategic defaults occurred nationwide during 2008, more than
double the total in 2007. They represented 18% of all serious delinquencies that extended for
more than 60 days in the fourth quarter of 2008.
[51]

Predatory lending[edit]
Predatory lending refers to the practice of unscrupulous lenders, to enter into "unsafe" or
"unsound" secured loans for inappropriate purposes.
[52]
A classic bait-and-switch method was
used by Countrywide, advertising low interest rates for home refinancing. Such loans were
written into mind-numbingly detailed contracts and then swapped for more expensive loan
products on the day of closing. Whereas the advertisement might have stated that 1% or 1.5%
interest would be charged, the consumer would be put into an adjustable rate mortgage (ARM) in
which the interest charged would be greater than the amount of interest paid. This created
negative amortization, which the credit consumer might not notice until long after the loan
transaction had been consummated.
Countrywide, sued by California Attorney General Jerry Brown for "Unfair Business Practices"
and "False Advertising" was making high cost mortgages "to homeowners with weak credit,
adjustable rate mortgages (ARMs) that allowed homeowners to make interest-only
payments.".
[53]
When housing prices decreased, homeowners in ARMs then had little incentive to
pay their monthly payments, since their home equity had disappeared. This caused
Countrywide's financial condition to deteriorate, ultimately resulting in a decision by the Office
of Thrift Supervision to seize the lender.
Countrywide, according to Republican Lawmakers, had involved itself in making low-cost loans
to politicians, for purposes of gaining political favors.
[54]

Former employees from Ameriquest, which was United States's leading wholesale lender,
[55]

described a system in which they were pushed to falsify mortgage documents and then sell the
mortgages to Wall Street banks eager to make fast profits.
[55]
There is growing evidence that
such mortgage frauds may be a large cause of the crisis.
[55]

Others have pointed to the passage of the GrammLeachBliley Act by the 106th Congress, and
over-leveraging by banks and investors eager to achieve high returns on capital.
Risk-taking behavior[edit]
In a June 2009 speech, U.S. President Barack Obama argued that a "culture of
irresponsibility"
[56]
was an important cause of the crisis. He criticized executive compensation
that "rewarded recklessness rather than responsibility" and Americans who bought homes
"without accepting the responsibilities." He continued that there "was far too much debt and not
nearly enough capital in the system. And a growing economy bred complacency."
[57]
Excessive
consumer housing debt was in turn caused by the mortgage-backed security, credit default swap,
and collateralized debt obligation sub-sectors of the finance industry, which were offering
irrationally low interest rates and irrationally high levels of approval to subprime mortgage
consumers. Formulas for calculating aggregate risk were based on the gaussian copula which
wrongly assumed that individual components of mortgages where independent. In fact the credit-
worthiness of almost every new subprime mortgage was highly correlated with that of any other,
due to linkages through consumer spending levels which fell sharply when property values began
to fall during the initial wave of mortgage defaults.
[58][59]
Debt consumers were acting in their
rational self-interest, because they were unable to audit the finance industry's opaque faulty risk
pricing methodology.
[60]

A key theme of the crisis is that many large financial institutions did not have a sufficient
financial cushion to absorb the losses they sustained or to support the commitments made to
others. Using technical terms, these firms were highly leveraged (i.e., they maintained a high
ratio of debt to equity) or had insufficient capital to post as collateral for their borrowing. A key
to a stable financial system is that firms have the financial capacity to support their
commitments.
[61]
Michael Lewis and David Einhorn argued: "The most critical role for
regulation is to make sure that the sellers of risk have the capital to support their bets."
[62]

Consumer and household borrowing[edit]
U.S. households and financial institutions became increasingly indebted or overleveraged during
the years preceding the crisis. This increased their vulnerability to the collapse of the housing
bubble and worsened the ensuing economic downturn.
USA household debt as a percentage of annual disposable personal income was 127% at the end
of 2007, versus 77% in 1990.
[63]

U.S. home mortgage debt relative to gross domestic product (GDP) increased from an average of
46% during the 1990s to 73% during 2008, reaching $10.5 trillion.
[64]

In 1981, U.S. private debt was 123% of GDP; by the third quarter of 2008, it was 290%.
[65]

Several economists and think tanks have argued that income inequality is one of the reasons for
this over-leveraging. The New York Times reported in October 2012 that research by the
Brookings Institution, the I.M.F. and dozens of economists at top research universities indicated
that starting in the 1970s, earnings were squeezed for low- and middle-income households. They
borrowed to improve their standards of living, buying bigger houses than they could afford and
using those houses as piggy banks. Research by Raghuram Rajan indicated that: Starting in the
early 1970s, advanced economies found it increasingly difficult to grow...the shortsighted
political response to the anxieties of those falling behind was to ease their access to credit. Faced
with little regulatory restraint, banks overdosed on risky loans."
[66]

Excessive private debt levels[edit]


U.S. household debt relative to disposable income and GDP.
In order to counter the Stock Market Crash of 2000 and the subsequent economic slowdown, the
Federal Reserve eased credit availability and drove interest rates down to lows not seen in many
decades. These low interest rates facilitated the growth of debt at all levels of the economy, chief
among them private debt to purchase more expensive housing. High levels of debt have long
been recognized as a causative factor for recessions.
[67]
Any debt default has the possibility of
causing the lender to also default, if the lender is itself in a weak financial condition and has too
much debt. This second default in turn can lead to still further defaults through a domino effect.
The chances of these follow-up defaults is increased at high levels of debt. Attempts to prevent
this domino effect by bailing out Wall Street lenders such as AIG, Fannie Mae, and Freddie Mac
have had mixed success. The takeover is another example of attempts to stop the dominoes from
falling.There was a real irony in the recent intervention by the Federal Reserve System to
provide the money that enabled the firm of JPMorgan Chase to buy Bear Stearns before it went
bankrupt. The point was to try to prevent a domino effect of panic in the financial markets that
could lead to a downturn in the economy.
Excessive consumer housing debt was in turn caused by the mortgage-backed security, credit
default swap, and collateralized debt obligation sub-sectors of the finance industry, which were
offering irrationally low interest rates and irrationally high levels of approval to subprime
mortgage consumers because they were calculating aggregate risk using gaussian copula
formulas that strictly assumed the independence of individual component mortgages, when in
fact the credit-worthiness almost every new subprime mortgage was highly correlated with that
of any other because of linkages through consumer spending levels which fell sharply when
property values began to fall during the initial wave of mortgage defaults.
[58][59]
Debt consumers
were acting in their rational self-interest, because they were unable to audit the finance industry's
opaque faulty risk pricing methodology.
[60]

According to M.S. Eccles, who was appointed chairman of the Federal Reserve by FDR and held
that position until 1948, excessive debt levels were not a source cause of the Great Depression.
Increasing debt levels were caused by a concentration of wealth during the 1920s, causing the
middle and poorer classes, which saw a relative and/or actual decrease in wealth, to go
increasingly into debt in an attempt to maintain or improve their living standards. According to
Eccles this concentration of wealth was the source cause of the Great Depression. The ever
increasing debt levels eventually became unpayable, and therefore unsustainable, leading to debt
defaults and the financial panics of the 1930s. The concentration of wealth in the modern era
parallels that of the 1920s and has had similar effects.
[68]
Some of the causes of wealth
concentration in the modern era are lower tax rates for the rich, such as Warren Buffett paying
taxes at a lower rate then the people working for him,
[69]
policies such as propping up the stock
market, which benefit the stock owning rich more than the middle or poorer classes who own
little or no stock, and bailouts which funnel tax money collected largely from the middle class to
bail out large corporations largely owned by the rich.
The International Monetary Fund (IMF) reported in April 2012: "Household debt soared in the
years leading up to the Great Recession. In advanced economies, during the five years preceding
2007, the ratio of household debt to income rose by an average of 39 percentage points, to 138
percent. In Denmark, Iceland, Ireland, the Netherlands, and Norway, debt peaked at more than
200 percent of household income. A surge in household debt to historic highs also occurred in
emerging economies such as Estonia, Hungary, Latvia, and Lithuania. The concurrent boom in
both house prices and the stock market meant that household debt relative to assets held broadly
stable, which masked households growing exposure to a sharp fall in asset prices. When house
prices declined, ushering in the global financial crisis, many households saw their wealth shrink
relative to their debt, and, with less income and more unemployment, found it harder to meet
mortgage payments. By the end of 2011, real house prices had fallen from their peak by about
41% in Ireland, 29% in Iceland, 23% in Spain and the United States, and 21% in Denmark.
Household defaults, underwater mortgages (where the loan balance exceeds the house value),
foreclosures, and fire sales are now endemic to a number of economies. Household deleveraging
by paying off debts or defaulting on them has begun in some countries. It has been most
pronounced in the United States, where about two-thirds of the debt reduction reflects
defaults.
[70][71]

Home equity extraction[edit]
This refers to homeowners borrowing and spending against the value of their homes, typically
via a home equity loan or when selling the home. Free cash used by consumers from home
equity extraction doubled from $627 billion in 2001 to $1,428 billion in 2005 as the housing
bubble built, a total of nearly $5 trillion over the period, contributing to economic growth
worldwide.
[72][73][74]
U.S. home mortgage debt relative to GDP increased from an average of 46%
during the 1990s to 73% during 2008, reaching $10.5 trillion.
[64]

Housing speculation[edit]
Speculative borrowing in residential real estate has been cited as a contributing factor to the
subprime mortgage crisis.
[75]
During 2006, 22% of homes purchased (1.65 million units) were for
investment purposes, with an additional 14% (1.07 million units) purchased as vacation homes.
During 2005, these figures were 28% and 12%, respectively. In other words, a record level of
nearly 40% of homes purchases were not intended as primary residences. David Lereah, NAR's
chief economist at the time, stated that the 2006 decline in investment buying was expected:
"Speculators left the market in 2006, which caused investment sales to fall much faster than the
primary market."
[76]

Housing prices nearly doubled between 2000 and 2006, a vastly different trend from the
historical appreciation at roughly the rate of inflation. While homes had not traditionally been
treated as investments subject to speculation, this behavior changed during the housing boom.
Media widely reported condominiums being purchased while under construction, then being
"flipped" (sold) for a profit without the seller ever having lived in them.
[77]
Some mortgage
companies identified risks inherent in this activity as early as 2005, after identifying investors
assuming highly leveraged positions in multiple properties.
[78]

Nicole Gelinas of the Manhattan Institute described the negative consequences of not adjusting
tax and mortgage policies to the shifting treatment of a home from conservative inflation hedge
to speculative investment.
[79]
Economist Robert Shiller argued that speculative bubbles are fueled
by "contagious optimism, seemingly impervious to facts, that often takes hold when prices are
rising. Bubbles are primarily social phenomena; until we understand and address the psychology
that fuels them, they're going to keep forming."
[80]

Mortgage risks were underestimated by every institution in the chain from originator to investor
by underweighting the possibility of falling housing prices given historical trends of rising
prices.
[81][82]
Misplaced confidence in innovation and excessive optimism led to miscalculations
by both public and private institutions.
Pro-cyclical human nature[edit]
Keynesian economist Hyman Minsky described how speculative borrowing contributed to rising
debt and an eventual collapse of asset values.
[83]
Economist Paul McCulley described how
Minsky's hypothesis translates to the current crisis, using Minsky's words: "...from time to time,
capitalist economies exhibit inflations and debt deflations which seem to have the potential to
spin out of control. In such processes, the economic system's reactions to a movement of the
economy amplify the movement--inflation feeds upon inflation and debt-deflation feeds upon
debt deflation." In other words, people are momentum investors by nature, not value investors.
People naturally take actions that expand the apex and nadir of cycles. One implication for
policymakers and regulators is the implementation of counter-cyclical policies, such as
contingent capital requirements for banks that increase during boom periods and are reduced
during busts.
[84]

Corporate risk-taking and leverage[edit]


Leverage ratios of investment banks increased significantly between 2003 and 2007.
The former CEO of Citigroup Charles O. Prince said in November 2007: "As long as the music
is playing, you've got to get up and dance." This metaphor summarized how financial institutions
took advantage of easy credit conditions, by borrowing and investing large sums of money, a
practice called leveraged lending.
[85]
Debt taken on by financial institutions increased from
63.8% of U.S. gross domestic product in 1997 to 113.8% in 2007.
[86]

Net capital rule[edit]
A 2004 SEC decision related to the net capital rule allowed USA investment banks to issue
substantially more debt, which was then used to help fund the housing bubble through purchases
of mortgage-backed securities.
[87]
The change in regulation left the capital adequacy requirement
at the same level but added a risk weighting that lowered capital requirements on AAA rated
bonds and tranches. This led to a shift from first loss tranches to highly-rated less risky tranches
and was seen as an improvement in risk management in the spirit of the European Basel
accords.
[88]

From 2004-07, the top five U.S. investment banks each significantly increased their financial
leverage (see diagram), which increased their vulnerability to a financial shock. These five
institutions reported over $4.1 trillion in debt for fiscal year 2007, about 30% of USA nominal
GDP for 2007. Lehman Brothers was liquidated, Bear Stearns and Merrill Lynch were sold at
fire-sale prices, and Goldman Sachs and Morgan Stanley became commercial banks, subjecting
themselves to more stringent regulation. With the exception of Lehman, these companies
required or received government support.
[87]

Fannie Mae and Freddie Mac, two U.S. government-sponsored enterprises, owned or guaranteed
nearly $5 trillion in mortgage obligations at the time they were placed into conservatorship by
the U.S. government in September 2008.
[89][90]

These seven entities were highly leveraged and had $9 trillion in debt or guarantee obligations,
an enormous concentration of risk, yet were not subject to the same regulation as depository
banks.
In a May 2008 speech, Ben Bernanke quoted Walter Bagehot: "A good banker will have
accumulated in ordinary times the reserve he is to make use of in extraordinary times."
[91]

However, this advice was not heeded by these institutions, which had used the boom times to
increase their leverage ratio instead.
Perverse incentives[edit]
The theory of laissez-faire capitalism suggests that financial institutions would be risk-averse
because failure would result in liquidation. But the Federal Reserve's 1984 rescue of Continental
Illinois and the 1998 rescue of the Long-Term Capital Management hedge fund, among others,
showed that institutions which failed to exercise due diligence could reasonably expect to be
protected from the consequences of their mistakes. The belief that they would not be allowed to
fail created a moral hazard, which allegedly contributed to the late-2000s recession.
[92]
(In "The
system" Eduardo Galeano wrote, "Bankruptcies are socialized, profits are privatized.")
[93]

However, even without the too big to fail syndrome, the short-term structure of compensation
packages creates perverse incentives for executives to maximize the short-term performance of
their companies at the expense of the long term. William K. Black developed the concept of
control fraud to describe executives who pervert good business rules to transfer substantial
wealth to themselves from shareholders and customers. Their companies may report phenomenal
profits in the short term only to lose substantial amounts of money when their Ponzi schemes
finally collapse. Some of the individuals Black described were prosecuted for fraud, but many
are allowed to keep their wealth with little more than a public rebuke that seems to have little
impact on their future.
[94]
Eileen Foster was fired as a Vice President of Bank of America for
trying too hard to inform her managers of systematic fraud in their home loans unit. Richard
Bowen, chief underwriter of Citigroup's consumer division, was demoted with 218 of his 220
employees reassigned allegedly for attempting to inform several senior executives that over 80
percent of their mortgages violated Citigroup's own standards.
[95]

Political Corruption[edit]
William K. Black insisted that we have effectively decriminalized elite financial fraud.
[96]

Financial market factors[edit]
In its "Declaration of the Summit on Financial Markets and the World Economy," dated 15
November 2008, leaders of the Group of 20 cited the following causes related to features of the
modern financial markets:
During a period of strong global growth, growing capital flows, and prolonged stability earlier
this decade, market participants sought higher yields without an adequate appreciation of the
risks and failed to exercise proper due diligence. At the same time, weak underwriting standards,
unsound risk management practices, increasingly complex and opaque financial products, and
consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers,
regulators and supervisors, in some advanced countries, did not adequately appreciate and
address the risks building up in financial markets, keep pace with financial innovation, or take
into account the systemic ramifications of domestic regulatory actions.
[97]

Financial product innovation[edit]


A protester on Wall Street in the wake of the AIG bonus payments controversy is interviewed by news
media.


IMF Diagram of CDO and RMBS
The term financial innovation refers to the ongoing development of financial products designed
to achieve particular client objectives, such as offsetting a particular risk exposure (such as the
default of a borrower) or to assist with obtaining financing. Examples pertinent to this crisis
included: the adjustable-rate mortgage; the bundling of subprime mortgages into mortgage-
backed securities (MBS) or collateralized debt obligations (CDO) for sale to investors, a type of
securitization;
[35]
and a form of credit insurance called credit default swaps(CDS).
[98]
The usage
of these products expanded dramatically in the years leading up to the crisis. These products vary
in complexity and the ease with which they can be valued on the books of financial
institutions.
[99]

The CDO in particular enabled financial institutions to obtain investor funds to finance subprime
and other lending, extending or increasing the housing bubble and generating large fees.
Approximately $1.6 trillion in CDO's were originated between 2003-2007.
[100]
A CDO
essentially places cash payments from multiple mortgages or other debt obligations into a single
pool, from which the cash is allocated to specific securities in a priority sequence. Those
securities obtaining cash first received investment-grade ratings from rating agencies. Lower
priority securities received cash thereafter, with lower credit ratings but theoretically a higher
rate of return on the amount invested.
[101][102]
A sample of 735 CDO deals originated between
1999 and 2007 showed that subprime and other less-than-prime mortgages represented an
increasing percentage of CDO assets, rising from 5% in 2000 to 36% in 2007.
[103]

For a variety of reasons, market participants did not accurately measure the risk inherent with
this innovation or understand its impact on the overall stability of the financial system.
[97]
For
example, the pricing model for CDOs clearly did not reflect the level of risk they introduced into
the system. The average recovery rate for "high quality" CDOs has been approximately 32 cents
on the dollar, while the recovery rate for mezzanine CDO's has been approximately five cents for
every dollar. These massive, practically unthinkable, losses have dramatically impacted the
balance sheets of banks across the globe, leaving them with very little capital to continue
operations.
[104]

Others have pointed out that there were not enough of these loans made to cause a crisis of this
magnitude. In an article in Portfolio Magazine, Michael Lewis spoke with one trader who noted
that "There werent enough Americans with [bad] credit taking out [bad loans] to satisfy
investors appetite for the end product." Essentially, investment banks and hedge funds used
financial innovation to synthesize more loans using derivatives. "They were creating [loans] out
of whole cloth. One hundred times over! Thats why the losses are so much greater than the
loans."
[105]

Princeton professor Harold James wrote that one of the byproducts of this innovation was that
MBS and other financial assets were "repackaged so thoroughly and resold so often that it
became impossible to clearly connect the thing being traded to its underlying value." He called
this a "...profound flaw at the core of the U.S. financial system..."
[106]

Another example relates to AIG, which insured obligations of various financial institutions
through the usage of credit default swaps.
[98]
The basic CDS transaction involved AIG receiving
a premium in exchange for a promise to pay money to party A in the event party B defaulted.
However, AIG did not have the financial strength to support its many CDS commitments as the
crisis progressed and was taken over by the government in September 2008. U.S. taxpayers
provided over $180 billion in government support to AIG during 2008 and early 2009, through
which the money flowed to various counterparties to CDS transactions, including many large
global financial institutions.
[107][108]

Author Michael Lewis wrote that CDS enabled speculators to stack bets on the same mortgage
bonds and CDO's. This is analogous to allowing many persons to buy insurance on the same
house. Speculators that bought CDS insurance were betting that significant defaults would occur,
while the sellers (such as AIG) bet they would not.
[99]
In addition, Chicago Public Radio and the
Huffington Post reported in April 2010 that market participants, including a hedge fund called
Magnetar Capital, encouraged the creation of CDO's containing low quality mortgages, so they
could bet against them using CDS. NPR reported that Magnetar encouraged investors to
purchase CDO's while simultaneously betting against them, without disclosing the latter
bet.
[109][110]

Inaccurate credit ratings[edit]
Main article: Credit rating agencies and the subprime crisis


MBS credit rating downgrades, by quarter.
Credit rating agencies are now under scrutiny for having given investment-grade ratings to
MBSs based on risky subprime mortgage loans. These high ratings enabled these MBS to be sold
to investors, thereby financing the housing boom. These ratings were believed justified because
of risk reducing practices, such as credit default insurance and equity investors willing to bear
the first losses.
[dubious discuss]
However, there are also indications that some involved in rating
subprime-related securities knew at the time that the rating process was faulty.
[111]

An estimated $3.2 trillion in loans were made to homeowners with bad credit and undocumented
incomes (e.g., subprime or Alt-A mortgages) between 2002 and 2007. Economist Joseph Stiglitz
stated: "I view the rating agencies as one of the key culprits...They were the party that performed
the alchemy that converted the securities from F-rated to A-rated. The banks could not have done
what they did without the complicity of the rating agencies." Without the AAA ratings, demand
for these securities would have been considerably less. Bank writedowns and losses on these
investments totaled $523 billion as of September 2008.
[112][113]

The ratings of these securities was a lucrative business for the rating agencies, accounting for just
under half of Moody's total ratings revenue in 2007. Through 2007, ratings companies enjoyed
record revenue, profits and share prices. The rating companies earned as much as three times
more for grading these complex products than corporate bonds, their traditional business. Rating
agencies also competed with each other to rate particular MBS and CDO securities issued by
investment banks, which critics argued contributed to lower rating standards. Interviews with
rating agency senior managers indicate the competitive pressure to rate the CDO's favorably was
strong within the firms. This rating business was their "golden goose" (which laid the proverbial
golden egg or wealth) in the words of one manager.
[113]
Author Upton Sinclair (18781968)
famously stated: "It is difficult to get a man to understand something when his job depends on
not understanding it."
[114]
From 2000-2006, structured finance (which includes CDO's) accounted
for 40% of the revenues of the credit rating agencies. During that time, one major rating agency
had its stock increase six-fold and its earnings grew by 900%.
[115]

Critics allege that the rating agencies suffered from conflicts of interest, as they were paid by
investment banks and other firms that organize and sell structured securities to investors.
[116]
On
11 June 2008, the SEC proposed rules designed to mitigate perceived conflicts of interest
between rating agencies and issuers of structured securities.
[117]
On 3 December 2008, the SEC
approved measures to strengthen oversight of credit rating agencies, following a ten-month
investigation that found "significant weaknesses in ratings practices," including conflicts of
interest.
[118]

Between Q3 2007 and Q2 2008, rating agencies lowered the credit ratings on $1.9 trillion in
mortgage-backed securities. Financial institutions felt they had to lower the value of their MBS
and acquire additional capital so as to maintain capital ratios. If this involved the sale of new
shares of stock, the value of the existing shares was reduced. Thus ratings downgrades lowered
the stock prices of many financial firms.
[119]

Lack of transparency and independence in financial modeling[edit]
The limitations of many, widely-used financial models also were not properly understood (see
for example
[120][121]
). Li's Gaussian copula formula assumed that the price of CDS was correlated
with and could predict the correct price of mortgage backed securities. Because it was highly
tractable, it rapidly came to be used by a huge percentage of CDO and CDS investors, issuers,
and rating agencies.
[121]
According to one wired.com article:
[121]
"Then the model fell apart.
Cracks started appearing early on, when financial markets began behaving in ways that users of
Li's formula hadn't expected. The cracks became full-fledged canyons in 2008when ruptures in
the financial system's foundation swallowed up trillions of dollars and put the survival of the
global banking system in serious peril... Li's Gaussian copula formula will go down in history as
instrumental in causing the unfathomable losses that brought the world financial system to its
knees."
As financial assets became more complex, less transparent, and harder and harder to value,
investors were reassured by the fact that both the international bond rating agencies and bank
regulators, who came to rely on them, accepted as valid some complex mathematical models
which theoretically showed the risks were much smaller than they actually proved to be in
practice.
[122]
George Soros commented that "The super-boom got out of hand when the new
products became so complicated that the authorities could no longer calculate the risks and
started relying on the risk management methods of the banks themselves. Similarly, the rating
agencies relied on the information provided by the originators of synthetic products. It was a
shocking abdication of responsibility."
[123]

Off-balance-sheet financing[edit]
Complex financing structures called structured investment vehicles (SIV) or conduits enabled
banks to move significant amounts of assets and liabilities, including unsold CDO's, off their
books.
[98]
This had the effect of helping the banks maintain regulatory minimum capital ratios.
They were then able to lend anew, earning additional fees. Author Robin Blackburn explained
how they worked:
[86]

Institutional investors could be persuaded to buy the SIV's supposedly high-quality, short-term
commercial paper, allowing the vehicles to acquire longer-term, lower quality assets, and
generating a profit on the spread between the two. The latter included larger amounts of
mortgages, credit-card debt, student loans and other receivables...For about five years those
dealing in SIV's and conduits did very well by exploiting the spread...but this disappeared in
August 2007, and the banks were left holding a very distressed baby.
Off balance sheet financing also made firms look less leveraged and enabled them to borrow at
cheaper rates.
[98]

Banks had established automatic lines of credit to these SIV and conduits. When the cash flow
into the SIV's began to decline as subprime defaults mounted, banks were contractually obligated
to provide cash to these structures and their investors. This "conduit-related balance sheet
pressure" placed strain on the banks' ability to lend, both raising interbank lending rates and
reducing the availability of funds.
[124]

In the years leading up to the crisis, the top four U.S. depository banks moved an estimated $5.2
trillion in assets and liabilities off-balance sheet into these SIV's and conduits. This enabled them
to essentially bypass existing regulations regarding minimum capital ratios, thereby increasing
leverage and profits during the boom but increasing losses during the crisis. Accounting
guidance was changed in 2009 that will require them to put some of these assets back onto their
books, which will significantly reduce their capital ratios. One news agency estimated this
amount to be between $500 billion and $1 trillion. This effect was considered as part of the stress
tests performed by the government during 2009.
[125]

During March 2010, the bankruptcy court examiner released a report on Lehman Brothers, which
had failed spectacularly in September 2008. The report indicated that up to $50 billion was
moved off-balance sheet in a questionable manner by management during 2008, with the effect
of making its debt level (leverage ratio) appear smaller.
[126]
Analysis by the Federal Reserve
Bank of New York indicated big banks mask their risk levels just prior to reporting data
quarterly to the public.
[127]

Regulatory avoidance[edit]
Certain financial innovation may also have the effect of circumventing regulations, such as off-
balance sheet financing that affects the leverage or capital cushion reported by major banks. For
example, Martin Wolf wrote in June 2009: "...an enormous part of what banks did in the early
part of this decade the off-balance-sheet vehicles, the derivatives and the 'shadow banking
system' itself was to find a way round regulation."
[128]

Financial sector concentration[edit]
Niall Ferguson wrote that the financial sector became increasingly concentrated in the years
leading up to the crisis, which made the stability of the financial system more reliant on just a
few firms, which were also highly leveraged:
[129]

Between 1990 and 2008, according to Wall Street veteran Henry Kaufman, the share of financial
assets held by the 10 largest U.S. financial institutions rose from 10 percent to 50 percent, even
as the number of banks fell from more than 15,000 to about 8,000. By the end of 2007, 15
institutions with combined shareholder equity of $857 billion had total assets of $13.6 trillion
and off-balance-sheet commitments of $5.8 trilliona total leverage ratio of 23 to 1. They also
had underwritten derivatives with a gross notional value of $216 trillion. These firms had once
been Wall Street's "bulge bracket," the companies that led underwriting syndicates. Now they did
more than bulge. These institutions had become so big that the failure of just one of them would
pose a systemic risk.
By contrast, some scholars have argued that fragmentation in the mortgage securitization market
led to increased risk taking and a deterioration in underwriting standards.
[35]

Governmental policies[edit]
Main article: Government policies and the subprime mortgage crisis


U.S. Subprime lending expanded dramatically 20042006.
Failure to regulate non-depository banking[edit]
The Shadow banking system grew to exceed the size of the depository system, but was not
subject to the same requirements and protections. Nobel laureate Paul Krugman described the
run on the shadow banking system as the "core of what happened" to cause the crisis. "As the
shadow banking system expanded to rival or even surpass conventional banking in importance,
politicians and government officials should have realized that they were re-creating the kind of
financial vulnerability that made the Great Depression possible and they should have
responded by extending regulations and the financial safety net to cover these new institutions.
Influential figures should have proclaimed a simple rule: anything that does what a bank does,
anything that has to be rescued in crises the way banks are, should be regulated like a bank." He
referred to this lack of controls as "malign neglect."
[130][131]

Affordable housing policies[edit]
Critics of government policy argued that government lending programs were the main cause of
the crisis.
[132][133][134][135][136][137][138]
The Financial Crisis Inquiry Commission (majority report)
stated that Fannie Mae and Freddie Mac, government affordable housing policies, and the
Community Reinvestment Act were not primary causes of the crisis.
[139][140]

Government deregulation as a cause[edit]
In 1992, the Democratic-controlled 102nd Congress under the George H. W. Bush
administration weakened regulation of Fannie Mae and Freddie Mac with the goal of making
available more money for the issuance of home loans. The Washington Post wrote: "Congress
also wanted to free up money for Fannie Mae and Freddie Mac to buy mortgage loans and
specified that the pair would be required to keep a much smaller share of their funds on hand
than other financial institutions. Whereas banks that held $100 could spend $90 buying mortgage
loans, Fannie Mae and Freddie Mac could spend $97.50 buying loans. Finally, Congress ordered
that the companies be required to keep more capital as a cushion against losses if they invested in
riskier securities. But the rule was never set during the Clinton administration, which came to
office that winter, and was only put in place nine years later."
[141]

Some economists have pointed to deregulation efforts as contributing to the collapse.
[142][143][144]

In 1999, the Republican controlled 106th Congress U.S. Congress under the Clinton
administration passed the Gramm-Leach-Bliley Act, which repealed part of the GlassSteagall
Act of 1933. This repeal has been criticized by some for having contributed to the proliferation
of the complex and opaque financial instruments which are at the heart of the crisis.
[145]

However, some economists object to singling out the repeal of GlassSteagall for criticism. Brad
DeLong, a former advisor to President Clinton and economist at the University of California,
Berkeley and Tyler Cowen of George Mason University have both argued that the Gramm-
Leach-Bliley Act softened the impact of the crisis by allowing for mergers and acquisitions of
collapsing banks as the crisis unfolded in late 2008.
[146]

Macroeconomic conditions[edit]
Two important factors that contributed to the United States housing bubble were low U.S.
interest rates and a large U.S. trade deficit. Low interest rates made bank lending more
profitable, while trade deficits resulted in large capital inflows to the U.S. Both made funds for
borrowing plentiful and relatively inexpensive.
Interest rates[edit]


Federal Funds Rate and Various Mortgage Rates
From 2000 to 2003, the Federal Reserve lowered the federal funds rate target from 6.5% to
1.0%.
[147]
This was done to soften the effects of the collapse of the dot-com bubble and of the
September 2001 terrorist attacks, and to combat the perceived risk of deflation.
[148]
The Fed then
raised the Fed funds rate significantly between July 2004 and July 2006.
[149]
This contributed to
an increase in 1-year and 5-year adjustable-rate mortgage (ARM) rates, making ARM interest
rate resets more expensive for homeowners.
[150]
This may have also contributed to the deflating
of the housing bubble, as asset prices generally move inversely to interest rates and it became
riskier to speculate in housing.
[151][152]

Globalization and Trade deficits[edit]


U.S. Current Account Deficit
Globalization and trade imbalances contributed to enormous inflows of money into the U.S. from
high savings countries, fueling debt-driven consumption and the housing bubble. The ratio of
household debt to disposable income rose from 77% in 1990 to 127% by 2007.
[63]
The steady
entry into the world economy of new export-oriented economies began with Japan and the Asian
tigers in the 1980s and peaked with China in the early 2000s, representing more than two billion
newly employable workers. The integration of these high-savings, lower wage economies into
the global economy, combined with dramatic productivity gains made possible by new
information technologies and the globalization of corporate supply chains, decisively shifted the
balance of global supply and demand. By 2000, the world economy was beset by excess supplies
of labor, capital, and productive capacity relative to global demand. But the collapse of the
consumer credit and housing price bubbles brought an end to this pattern of debt-financed
economic growth and left the U.S. with the massive debt overhang.
[153]

This globalization can be measured in growing trade deficits in developed countries such as the
U.S. and Europe. In 2005, Ben Bernanke addressed the implications of the USA's high and rising
current account deficit, resulting from USA imports exceeding its exports, which was itself
caused by a global saving glut.
[154]
Between 1996 and 2004, the USA current account deficit
increased by $650 billion, from 1.5% to 5.8% of GDP. Financing these deficits required the USA
to borrow large sums from abroad, much of it from countries running trade surpluses, mainly the
emerging economies in Asia and oil-exporting nations. The balance of payments identity
requires that a country (such as the USA) running a current account deficit also have a capital
account (investment) surplus of the same amount. Hence large and growing amounts of foreign
funds (capital) flowed into the USA to finance its imports. This created demand for various types
of financial assets, raising the prices of those assets while lowering interest rates. Foreign
investors had these funds to lend, either because they had very high personal savings rates (as
high as 40% in China), or because of high oil prices. Bernanke referred to this as a "saving
glut."
[155]
A "flood" of funds (capital or liquidity) reached the USA financial markets. Foreign
governments supplied funds by purchasing USA Treasury bonds and thus avoided much of the
direct impact of the crisis. USA households, on the other hand, used funds borrowed from
foreigners to finance consumption or to bid up the prices of housing and financial assets.
Financial institutions invested foreign funds in mortgage-backed securities. USA housing and
financial assets dramatically declined in value after the housing bubble burst.
[156][157]

Chinese mercantilism[edit]
Martin Wolf has argued that "inordinately mercantilist currency policies" were a significant
cause of the U.S. trade deficit, indirectly driving a flood of money into the U.S. as described
above. In his view, China maintained an artificially weak currency to make Chinese goods
relatively cheaper for foreign countries to purchase, thereby keeping its vast workforce occupied
and encouraging exports to the U.S. One byproduct was a large accumulation of U.S. dollars by
the Chinese government, which were then invested in U.S. government securities and those of
Fannie Mae and Freddie Mac, providing additional funds for lending that contributed to the
housing bubble.
[158][159]

Economist Paul Krugman also wrote similar comments during October 2009, further arguing that
China's currency should have appreciated relative to the U.S. dollar beginning around 2001.
[160]

Various U.S. officials have also indicated concerns with Chinese exchange rate policies, which
have not allowed its currency to appreciate significantly relative to the dollar despite large trade
surpluses. In January 2009, Timothy Geithner wrote: "Obama -- backed by the conclusions of a
broad range of economists -- believes that China is manipulating its currency...the question is
how and when to broach the subject in order to do more good than harm."
[161]

End of a long wave[edit]
The cause of the crisis can be seen also in principles of technological development and in long
economic waves based on technological revolutions. Daniel mihula believes that this crisis and
stagnation are a result of the end of the long economic cycle originally initiated by the
Information and telecommunications technological revolution in 1985-2000.
[162]
The market has
been already saturated by new technical wonders (e.g. everybody has his own mobile phone)
and what is more important - in the developed countries the economy reached limits of
productivity in conditions of existing technologies. A new economic revival can come only with
a new technological revolution (a hypothetical Post-informational technological revolution).
mihula expects that it will happen in about 2014-15.
Paradoxes of thrift and deleveraging[edit]
Behavior that may be optimal for an individual (e.g., saving more during adverse economic
conditions) can be detrimental if too many individuals pursue the same behavior, as ultimately
one person's consumption is another person's income. This is called the paradox of thrift.
Economist Hyman Minsky also described a "paradox of deleveraging" as financial institutions
that have too much leverage (debt relative to equity) cannot all de-leverage simultaneously
without significant declines in the value of their assets.
During April 2009, U.S. Federal Reserve Vice Chair Janet Yellen discussed these paradoxes:
"Once this massive credit crunch hit, it didnt take long before we were in a recession. The
recession, in turn, deepened the credit crunch as demand and employment fell, and credit losses
of financial institutions surged. Indeed, we have been in the grips of precisely this adverse
feedback loop for more than a year. A process of balance sheet deleveraging has spread to nearly
every corner of the economy. Consumers are pulling back on purchases, especially on durable
goods, to build their savings. Businesses are cancelling planned investments and laying off
workers to preserve cash. And, financial institutions are shrinking assets to bolster capital and
improve their chances of weathering the current storm. Once again, Minsky understood this
dynamic. He spoke of the paradox of deleveraging, in which precautions that may be smart for
individuals and firmsand indeed essential to return the economy to a normal state
nevertheless magnify the distress of the economy as a whole."
[4]

Capital market pressures[edit]
Private capital and the search for yield[edit]
In a Peabody Award winning program, NPR correspondents argued that a "Giant Pool of
Money" (represented by $70 trillion in worldwide fixed income investments) sought higher
yields than those offered by U.S. Treasury bonds early in the decade, which were low due to low
interest rates and trade deficits discussed above. Further, this pool of money had roughly doubled
in size from 2000 to 2007, yet the supply of relatively safe, income generating investments had
not grown as fast. Investment banks on Wall Street answered this demand with the mortgage-
backed security (MBS) and collateralized debt obligation (CDO), which were assigned safe
ratings by the credit rating agencies. In effect, Wall Street connected this pool of money to the
mortgage market in the U.S., with enormous fees accruing to those throughout the mortgage
supply chain, from the mortgage broker selling the loans, to small banks that funded the brokers,
to the giant investment banks behind them. By approximately 2003, the supply of mortgages
originated at traditional lending standards had been exhausted. However, continued strong
demand for MBS and CDO began to drive down lending standards, as long as mortgages could
still be sold along the supply chain.
[35]
Eventually, this speculative bubble proved
unsustainable.
[163]

Boom and collapse of the shadow banking system[edit]
Significance of the parallel banking system[edit]


Securitization markets were impaired during the crisis
In a June 2008 speech, U.S. Treasury Secretary Timothy Geithner, then President and CEO of
the NY Federal Reserve Bank, placed significant blame for the freezing of credit markets on a
"run" on the entities in the "parallel" banking system, also called the shadow banking system.
These entities became critical to the credit markets underpinning the financial system, but were
not subject to the same regulatory controls. Further, these entities were vulnerable because they
borrowed short-term in liquid markets to purchase long-term, illiquid and risky assets. This
meant that disruptions in credit markets would make them subject to rapid deleveraging, selling
their long-term assets at depressed prices. He described the significance of these entities: "In
early 2007, asset-backed commercial paper conduits, in structured investment vehicles, in
auction-rate preferred securities, tender option bonds and variable rate demand notes, had a
combined asset size of roughly $2.2 trillion. Assets financed overnight in triparty repo grew to
$2.5 trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The combined balance
sheets of the then five major investment banks totaled $4 trillion. In comparison, the total assets
of the top five bank holding companies in the United States at that point were just over $6
trillion, and total assets of the entire banking system were about $10 trillion." He stated that the
"combined effect of these factors was a financial system vulnerable to self-reinforcing asset price
and credit cycles."
[164]

Run on the shadow banking system[edit]
Nobel laureate and liberal political columnist Paul Krugman described the run on the shadow
banking system as the "core of what happened" to cause the crisis. "As the shadow banking
system expanded to rival or even surpass conventional banking in importance, politicians and
government officials should have realized that they were re-creating the kind of financial
vulnerability that made the Great Depression possibleand they should have responded by
extending regulations and the financial safety net to cover these new institutions. Influential
figures should have proclaimed a simple rule: anything that does what a bank does, anything that
has to be rescued in crises the way banks are, should be regulated like a bank." He referred to
this lack of controls as "malign neglect."
[130]
Some researchers have suggested that competition
between GSEs and the shadow banking system led to a deterioration in underwriting
standards.
[35]

For example, investment bank Bear Stearns was required to replenish much of its funding in
overnight markets, making the firm vulnerable to credit market disruptions. When concerns arose
regarding its financial strength, its ability to secure funds in these short-term markets was
compromised, leading to the equivalent of a bank run. Over four days, its available cash declined
from $18 billion to $3 billion as investors pulled funding from the firm. It collapsed and was sold
at a fire-sale price to bank JP Morgan Chase March 16, 2008.
[165][166][167]

American homeowners, consumers, and corporations owed roughly $25 trillion during 2008.
American banks retained about $8 trillion of that total directly as traditional mortgage loans.
Bondholders and other traditional lenders provided another $7 trillion. The remaining $10 trillion
came from the securitization markets, meaning the parallel banking system. The securitization
markets started to close down in the spring of 2007 and nearly shut-down in the fall of 2008.
More than a third of the private credit markets thus became unavailable as a source of
funds.
[168][169]
In February 2009, Ben Bernanke stated that securitization markets remained
effectively shut, with the exception of conforming mortgages, which could be sold to Fannie
Mae and Freddie Mac.
[170]

The Economist reported in March 2010: "Bear Stearns and Lehman Brothers were non-banks that
were crippled by a silent run among panicky overnight "repo" lenders, many of them money
market funds uncertain about the quality of securitized collateral they were holding. Mass
redemptions from these funds after Lehman's failure froze short-term funding for big firms."
[171]

Mortgage compensation model, executive pay and
bonuses[edit]
During the boom period, enormous fees were paid to those throughout the mortgage supply
chain, from the mortgage broker selling the loans, to small banks that funded the brokers, to the
giant investment banks behind them. Those originating loans were paid fees for selling them,
regardless of how the loans performed. Default or credit risk was passed from mortgage
originators to investors using various types of financial innovation.
[163]
This became known as
the "originate to distribute" model, as opposed to the traditional model where the bank
originating the mortgage retained the credit risk. In effect, the mortgage originators were left
with nothing which was at risk, giving rise to moral hazard in which behavior and consequence
were separated.
Economist Mark Zandi described moral hazard as a root cause of the subprime mortgage crisis.
He wrote: "...the risks inherent in mortgage lending became so widely dispersed that no one was
forced to worry about the quality of any single loan. As shaky mortgages were combined,
diluting any problems into a larger pool, the incentive for responsibility was undermined." He
also wrote: "Finance companies weren't subject to the same regulatory oversight as banks.
Taxpayers weren't on the hook if they went belly up [pre-crisis], only their shareholders and
other creditors were. Finance companies thus had little to discourage them from growing as
aggressively as possible, even if that meant lowering or winking at traditional lending
standards."
[172]

The New York State Comptroller's Office has said that in 2006, Wall Street executives took
home bonuses totaling $23.9 billion. "Wall Street traders were thinking of the bonus at the end of
the year, not the long-term health of their firm. The whole systemfrom mortgage brokers to
Wall Street risk managersseemed tilted toward taking short-term risks while ignoring long-
term obligations. The most damning evidence is that most of the people at the top of the banks
didn't really understand how those [investments] worked."
[16][173]

Investment banker incentive compensation was focused on fees generated from assembling
financial products, rather than the performance of those products and profits generated over time.
Their bonuses were heavily skewed towards cash rather than stock and not subject to "claw-
back" (recovery of the bonus from the employee by the firm) in the event the MBS or CDO
created did not perform. In addition, the increased risk (in the form of financial leverage) taken
by the major investment banks was not adequately factored into the compensation of senior
executives.
[174]

Bank CEO Jamie Dimon argued: "Rewards have to track real, sustained, risk-adjusted
performance. Golden parachutes, special contracts, and unreasonable perks must disappear.
There must be a relentless focus on risk management that starts at the top of the organization and
permeates down to the entire firm. This should be business-as-usual, but at too many places, it
wasn't."
[175]

Regulation and Deregulation[edit]
Further information: Government policies and the subprime mortgage crisis
Critics have argued that the regulatory framework did not keep pace with financial innovation,
such as the increasing importance of the shadow banking system, derivatives and off-balance
sheet financing. In other cases, laws were changed or enforcement weakened in parts of the
financial system. Several critics have argued that the most critical role for regulation is to make
sure that financial institutions have the ability or capital to deliver on their commitments.
[62][176]

Critics have also noted de facto deregulation through a shift in market share toward the least
regulated portions of the mortgage market.
[35]

Key examples of regulatory failures include:
In 1999, the Republican controlled 106th Congress U.S. Congress under the Clinton
administration passed the Gramm-Leach-Bliley Act, which repealed part of the GlassSteagall
Act of 1933.
[177]
This repeal has been criticized for reducing the separation between commercial
banks (which traditionally had a conservative culture) and investment banks (which had a more
risk-taking culture).
[178][179]

In 2004, the Securities and Exchange Commission relaxed the net capital rule, which enabled
investment banks to substantially increase the level of debt they were taking on, fueling the
growth in mortgage-backed securities supporting subprime mortgages. The SEC has conceded
that self-regulation of investment banks contributed to the crisis.
[180][181]

Financial institutions in the shadow banking system are not subject to the same regulation as
depository banks, allowing them to assume additional debt obligations relative to their financial
cushion or capital base.
[130]
This was the case despite the Long-Term Capital Management
debacle in 1998, where a highly-leveraged shadow institution failed with systemic implications.
Regulators and accounting standard-setters allowed depository banks such as Citigroup to move
significant amounts of assets and liabilities off-balance sheet into complex legal entities called
structured investment vehicles, masking the weakness of the capital base of the firm or degree
of leverage or risk taken. One news agency estimated that the top four U.S. banks will have to
return between $500 billion and $1 trillion to their balance sheets during 2009.
[182]
This
increased uncertainty during the crisis regarding the financial position of the major banks.
[183]

Off-balance sheet entities were also used by Enron as part of the scandal that brought down
that company in 2001.
[184]

The U.S. Congress allowed the self-regulation of the derivatives market when it passed the
Commodity Futures Modernization Act of 2000. Derivatives such as credit default swaps (CDS)
can be used to hedge or speculate against particular credit risks. The volume of CDS outstanding
increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS contracts, as
of November 2008, ranging from US$33 to $47 trillion. Total over-the-counter (OTC) derivative
notional value rose to $683 trillion by June 2008.
[185]
Warren Buffett famously referred to
derivatives as "financial weapons of mass destruction" in early 2003.
[186][187]

Author Roger Lowenstein summarized some of the regulatory problems that caused the crisis in
November 2009: "1) Mortgage regulation was too lax and in some cases nonexistent; 2) Capital
requirements for banks were too low; 3) Trading in derivatives such as credit default swaps
posed giant, unseen risks; 4) Credit ratings on structured securities such as collateralized-debt
obligations were deeply flawed; 5) Bankers were moved to take on risk by excessive pay
packages; 6) The governments response to the crash also created, or exacerbated, moral hazard.
Markets now expect that big banks wont be allowed to fail, weakening the incentives of
investors to discipline big banks and keep them from piling up too many risky assets again."
[188]

Conflicts of interest and lobbying[edit]
A variety of conflicts of interest have been argued as contributing to this crisis:
Credit rating agencies are compensated for rating debt securities by those issuing the securities,
who have an interest in seeing the most positive ratings applied. Further, changing the debt
rating on a company that insures multiple debt securities such as AIG or MBIA, requires the re-
rating of many other securities, creating significant costs. Despite taking on significantly more
risk, AIG and MBIA retained the highest credit ratings until well into the crisis.
[189]

There is a "revolving door" between major financial institutions, the Treasury Department, and
Treasury bailout programs. For example, the former CEO of Goldman Sachs was Henry Paulson,
who became President George W. Bush's Treasury Secretary. Although three of Goldman's key
competitors either failed or were allowed to fail, it received $10 billion in Troubled Asset Relief
Program (TARP) funds (which it has since paid back) and $12.9 billion in payments via AIG, while
remaining highly profitable and paying enormous bonuses. The first two officials in charge of the
TARP bailout program were also from Goldman.
[190]

There is a "revolving door" between major financial institutions and the Securities and Exchange
Commission (SEC), which is supposed to monitor them. For example, as of January 2009, the
SEC's two most recent Directors of Enforcement had taken positions at powerful banks directly
after leaving the role. The route into lucrative positions with banks places a financial incentive
on regulators to maintain good relationships with those they monitor. This is sometimes
referred to as regulatory capture.
[189]

Banks in the U.S. lobby politicians extensively. A November 2009 report from economists of the
International Monetary Fund (IMF) writing independently of that organization indicated that:
Firms that lobby aggressively are more likely to engage in risky securitization of their loan books,
have faster-growing mortgage loan portfolios as well as poorer share performance and larger
loan defaults;
Thirty-three legislative proposals that would have increased regulatory scrutiny over banks were
the targets of intense and successful lobbying;
US business spends $4.2 billion over the four-year election cycle on "targeted political activity",
with finance, insurance and real estate ("FIRE") firms accounting for 15% of that total ($479,500
per firm) in 2006; and
The "lobbying intensity" of the FIRE sector also "increased at a much faster pace relative to the
average lobbying intensity over 1999-2006."
The study concluded that: "the prevention of future crises might require weakening political
influence of the financial industry or closer monitoring of lobbying activities to understand better
the incentives behind it."
[191][192]

The Boston Globe reported during that during JanuaryJune 2009, the largest four U.S. banks
spent these amounts ($ millions) on lobbying, despite receiving taxpayer bailouts: Citigroup
$3.1; JP Morgan Chase $3.1; Bank of America $1.5; and Wells Fargo $1.4.
[193]

The New York Times reported in April 2010: "An analysis by Public Citizen found that at least
70 former members of Congress were lobbying for Wall Street and the financial services sector
last year, including two former Senate majority leaders (Trent Lott and Bob Dole), two former
House majority leaders (Richard A. Gephardt and Dick Armey) and a former House speaker (J.
Dennis Hastert). In addition to the lawmakers, data from the Center for Responsive Politics
counted 56 former Congressional aides on the Senate or House banking committees who went on
to use their expertise to lobby for the financial sector."
[194]

The Financial Crisis Inquiry Commission reported in January 2011 that "...from 1998 to 2008,
the financial sector expended $2.7 billion in reported federal lobbying expenses; individuals and
political action committees in the sector made more than $1 billion in campaign
contributions."
[195]

Other factors[edit]
Commodity price volatility[edit]
Main article: 2000s commodities boom
A commodity price bubble was created following the collapse in the housing bubble. The price
of oil nearly tripled from $50 to $140 from early 2007 to 2008, before plunging as the financial
crisis began to take hold in late 2008.
[196]
Experts debate the causes, which include the flow of
money from housing and other investments into commodities to speculation and monetary
policy.
[197]
An increase in oil prices tends to divert a larger share of consumer spending into
gasoline, which creates downward pressure on economic growth in oil importing countries, as
wealth flows to oil-producing states.
[198]
Spiking instability in the price of oil over the decade
leading up to the price high of 2008 has also been proposed as a causal factor in the financial
crisis.
[199]

Inaccurate economic forecasting[edit]
A cover story in BusinessWeek magazine claims that economists mostly failed to predict the
worst international economic crisis since the Great Depression of 1930s.
[200]
The Wharton
School of the University of Pennsylvania online business journal examines why economists
failed to predict a major global financial crisis.
[201]
An article in the New York Times informs
that economist Nouriel Roubini warned of such crisis as early as September 2006, and the article
goes on to state that the profession of economics is bad at predicting recessions.
[202]
According to
The Guardian, Roubini was ridiculed for predicting a collapse of the housing market and
worldwide recession, while The New York Times labelled him "Dr. Doom".
[203]
However, there
are examples of other experts who gave indications of a financial crisis.
[204][205][206]

Monetary expansion and uncertainty[edit]
An empirical study by John B. Taylor concluded that the crisis was: (1) caused by excess
monetary expansion; (2) prolonged by an inability to evaluate counter-party risk due to opaque
financial statements; and (3) worsened by the unpredictable nature of government's response to
the crisis.
[207][208]

Over-leveraging, credit default swaps and collateralized debt obligations as causes[edit]


Public debt as a percent of GDP (2007).


Public debt as a percent of GDP (2009/2010).
Another probable cause of the crisisand a factor that unquestionably amplified its magnitude
was widespread miscalculation by banks and investors of the level of risk inherent in the
unregulated Collateralized debt obligation and credit default swap markets. Under this theory,
banks and investors systematized the risk by taking advantage of low interest rates to borrow
tremendous sums of money that they could only pay back if the housing market continued to
increase in value.
According to an article published in Wired, the risk was further systematized by the use of David
X. Li's Gaussian copula model function to rapidly price Collateralized debt obligations based on
the price of related credit default swaps.
[209]
Because it was highly tractable, it rapidly came to be
used by a huge percentage of CDO and CDS investors, issuers, and rating agencies.
[209]

According to one wired.com article: "Then the model fell apart. Cracks started appearing early
on, when financial markets began behaving in ways that users of Li's formula hadn't expected.
The cracks became full-fledged canyons in 2008when ruptures in the financial system's
foundation swallowed up trillions of dollars and put the survival of the global banking system in
serious peril...Li's Gaussian copula formula will go down in history as instrumental in causing
the unfathomable losses that brought the world financial system to its knees."
[209]

The pricing model for CDOs clearly did not reflect the level of risk they introduced into the
system. It has been estimated that the "from late 2005 to the middle of 2007, around $450bn of
CDO of ABS were issued, of which about one third were created from risky mortgage-backed
bonds...[o]ut of that pile, around $305bn of the CDOs are now in a formal state of default, with
the CDOs underwritten by Merrill Lynch accounting for the biggest pile of defaulted assets,
followed by UBS and Citi."
[210]
The average recovery rate for high quality CDOs has been
approximately 32 cents on the dollar, while the recovery rate for mezzanine CDO's has been
approximately five cents for every dollar. These massive, practically unthinkable, losses have
dramatically impacted the balance sheets of banks across the globe, leaving them with very little
capital to continue operations.
[210]

Credit creation as a cause[edit]
Austrian economics argue that the crisis is consistent with the Austrian Business Cycle Theory,
in which credit created through the policies of central banking gives rise to an artificial boom,
which is inevitably followed by a bust. This perspective argues that the monetary policy of
central banks creates excessive quantities of cheap credit by setting interest rates below where
they would be set by a free market. This easy availability of credit inspires a bundle of
malinvestments, particularly on long term projects such as housing and capital assets, and also
spurs a consumption boom as incentives to save are diminished. Thus an unsustainable boom
arises, characterized by malinvestments and overconsumption.
But the created credit is not backed by any real savings nor is in response to any change in the
real economy, hence, there are physically not enough resources to finance either the
malinvestments or the consumption rate indefinitely. The bust occurs when investors collectively
realize their mistake. This happens usually some time after interest rates rise again. The
liquidation of the malinvestments and the consequent reduction in consumption throw the
economy into a recession, whose severity mirrors the scale of the boom's excesses.
Austrian economists argue that the conditions previous to the crisis of the late 2000s correspond
to the scenario described above. The central bank of the United States, led by Federal Reserve
Chairman Alan Greenspan, kept interest rates very low for a long period of time to blunt the
recession of the early 2000s. The resulting malinvestment and over-consumption of investors and
consumers prompted the development of a housing bubble that ultimately burst, precipitating the
financial crisis. The resulting devaluation of investors' share portfolio reduced consumption even
further and aggravated the consequences of the bursting of the bubble, since in the post-Bretton
Woods finance-led model of capitalism the stock market had transformed from a mechanism that
used to finance the supply side of the economy into a mechanism that financed the consumption
side;
[211]
thus, consumers' purchasing power evaporated together with the value of their stock
portfolio. This crisis, together with sudden and necessary deleveraging and cutbacks by
consumers, businesses and banks, led to the recession. Austrian Economists argue further that
while they probably affected the nature and severity of the crisis, factors such as a lack of
regulation, the Community Reinvestment Act, and entities such as Fannie Mae and Freddie Mac
are insufficient by themselves to explain it.
[212]

A positively sloped yield curve allows Primary Dealers (such as large investment banks) in the
Federal Reserve system to fund themselves with cheap short term money while lending out at
higher long-term rates. This strategy is profitable so long as the yield curve remains positively
sloped. However, it creates a liquidity risk if the yield curve were to become inverted and banks
would have to refund themselves at expensive short term rates while losing money on longer
term loans.
[citation needed]

The narrowing of the yield curve from 2004 and the inversion of the yield curve during 2007
resulted (with the expected 1 to 3 year delay) in a bursting of the housing bubble and a wild
gyration of commodities prices as moneys flowed out of assets like housing or stocks and sought
safe haven in commodities. The price of oil rose to over $140 per barrel in 2008 before plunging
as the financial crisis began to take hold in late 2008.
Other observers have doubted the role that the yield curve plays in controlling the business cycle.
In a May 24, 2006 story CNN Money reported: "...in recent comments, Fed Chairman Ben
Bernanke repeated the view expressed by his predecessor Alan Greenspan that an inverted yield
curve is no longer a good indicator of a recession ahead."
[citation needed]

An empirical study by John B. Taylor concluded that the crisis was: (1) caused by excess
monetary expansion; (2) prolonged by an inability to evaluate counter-party risk due to opaque
financial statements; and (3) worsened by the unpredictable nature of government's response to
the crisis.
[213][214]

Oil prices[edit]
Further information: Peak oil
Economist James D. Hamilton has argued that the increase in oil prices in the period of 2007
through 2008 was a significant cause of the recession. He evaluated several different approaches
to estimating the impact of oil price shocks on the economy, including some methods that had
previously shown a decline in the relationship between oil price shocks and the overall economy.
All of these methods "support a common conclusion; had there been no increase in oil prices
between 2007:Q3 and 2008:Q2, the US economy would not have been in a recession over the
period 2007:Q4 through 2008:Q3."
[215]
Hamilton's own model, a time-series econometric
forecast based on data up to 2003, showed that the decline in GDP could have been successfully
predicted to almost its full extent given knowledge of the price of oil. The results imply that oil
prices were entirely responsible for the recession.
[216][217]
Hamilton acknowledged that this was
probably not the entire cause but maintained that it showed that oil price increases made a
significant contribution to the downturn in economic growth.
[218]

Emigration[edit]
A significant reverse migration of illegal immigrants from the US back to Mexico began in 2006.
Approximately 0.5 million dwellings have become permanently vacant as a result of a reduction
in the illegal immigrant population. The greatest impact has been on the California economy,
where illegal immigrants comprise approximately 1/3 of the total population. The reduced
demand for housing created permanent unemployment for hundreds of thousands of building
contractors, realtors, and mortgage brokers.
[219][220]

Foreign investment in Mexico by businesses located in China and Venezuela have increased
employment opportunities in Mexico. The number of illegal immigrants living in the US
declined by 1.5 million since 2007, or about 12% of the total illegal immigrant workforce. The
economic decline caused by reduced spending by illegal immigrants in the US occurred at the
same time as a rise in unemployment of approximately 1 million legal US workers that provide
goods and services for the illegal immigrant population. This increased the number of
foreclosures and reduced automotive sales, contributing to an overall decline in value for real
estate, vehicles, and other property.
Economic activity produced by illegal immigrant spending employs about 5% of the total US
workforce. Illegal immigrants occupy over 3 million dwellings, or just under 4% of the total
number of homes in the US. UCLA research indicates illegal immigrants produce $150 billion of
economic activity equivalent to spending stimulus every year. Nearly every dollar earned by
illegal immigrants is spent immediately, and the average wage for US citizens is $10.25/hour
with an average of 34 hours per week, so approximately 8 million US jobs are dependent upon
economic activity produced by illegal immigrant activities within the US.
[221][222][223]

Overproduction[edit]
It has also been debated that the root cause of the crisis is overproduction of goods caused by
globalization
[224]
(and especially vast investments in countries such as China and India by
western multinational companies over the past 1520 years, which greatly increased global
industrial output at a reduced cost). Overproduction tends to cause deflation and signs of
deflation were evident in October and November 2008, as commodity prices tumbled and the
Federal Reserve was lowering its target rate to an all-time-low 0.25%.
[225]
On the other hand,
Professor Herman Daly suggests that it is not actually an economic crisis, but rather a crisis of
overgrowth beyond sustainable ecological limits.
[226]
This reflects a claim made in the 1972 book
Limits to Growth, which stated that without major deviation from the policies followed in the
20th century, a permanent end of economic growth could be reached sometime in the first two
decades of the 21st century, due to gradual depletion of natural resources.
[227]

As Sanusi Is Suspended, Is
Nigeria Still The World's
New Investment Darling?
Comment Now
Follow Comments
Correction: A previous version of this post incorrectly referred to Nigerian President
Goodluck Ebele Jonathan as President Johnson. The post has been corrected.
As Nigeria has shifted from a corruption-addled frontier state to one of the worlds few
emerging market bright spots, it has been assisted enormously by the charisma and
gravitas of two of its financial leaders. One is the coordinating minister for the economy and
minister of finance, Ngozi Okonjo-Iweala, familiar on the multilateral bank meeting circuit
for her strong leadership, candidacy for the world Bank presidency and her colourful
headscarves. The other is central bank governor Sanusi Lamido Sanusi, sharp-suited and
sharper-minded. Its never been entirely clear how well the two people, or at least their
institutions, get along, but they present to the world a credible, smart, articulate face for a
country whose finances have often been murky.
But now Sanusi, who was due to step down in June, has been suspended by President
Goodluck Ebele Jonathan over allegations of financial recklessness and misconduct. Few in
the west take these words taken verbatim from a statement issued by the president
through his media adviser, Reuben Abati at face value, and the result has been to erode
confidence in one of the few market darlings of frontier-spirited fund managers in recent
years.
Libya Takes On Goldman Sachs Chris Wright Contributor
After The Fragile Five, The Exposed Eight: The Bad News About BRICS and MINTs
Chris Wright Contributor
Investing: The Final Frontier Chris Wright Contributor
After The BRICS Are The MINTs, But Can You Make Any Money From Them? Chris
Wright Contributor
Its fair to say that Sanusi has, from the outset, taken on the big fights.
The first of them was taking on endemic financial fraud in the aftermath of a collapse in the
countrys whole banking system in 2009. This was difficult he sacked eight chief
executives of Nigerian banks in his first four months but considered a success story.
The last of them the very last, it seems was to take on corruption in the national oil
industry. In February he released a stack of documents suggesting that Nigerias oil funds,
the lifeblood of the national economy, were being mismanaged. Since oil revenues generally
account for more than 70% of government revenue, any fraud within this sector is
consumingly important for what is probably Africas largest economy (were all awaiting a
restatement of national GDP which will very likely elevate it about South Africa). Falling oil
income has caused problems with state finances and spending, foreign reserves, and
Nigerias own currency, the naira, which has been falling sharply this year. There were
hundreds of pages of data in the cache, but the key point is an allegation that more than $1
billion per month in crude sales, owed to the state, was not being remitted by the Nigerian
National Petroleum Corporation.
It is rumoured that President Jonathan had asked Sanusi to resign earlier, but he has now
moved to suspend the governor in the strongest possible terms. The statement says
Sanusis tenure has been characterized by various acts of financial recklessness and
misconduct, talks about far-reaching irregularities under Mallam Sanusis watch, and
urges his successor, deputy governor Sarah Alade, to focus on the core mandate of the
bank and conduct its affairs with greater professionalism, prudence and propriety to restore
domestic and international confidence in the countrys apex bank.
Until recently, Nigeria had been much-loved among frontier investors, for several reasons.
Firstly, the size of its GDP; secondly, its demographic position, with a young population
chiefly within the workforce age bracket; thirdly, oil; and fourthly, a sense that it was
cleaning up. High bond yields helped to drive heavy inflows into the currency last year. But
even prior to Sanusis removal, the gloss had started to come off, as foreign exchange
reserves had declined $7 billion from a $49 billion peak in April 2013, the naira had been
falling, and next years election had begun to distort spending patterns and clarity in policy.
News of Sanusis removal made things worse: bond trading was halted and the naira fell still
further. Samir Gadio at Standard Bank said the move was disruptive and showed the
Central Bank of Nigeria has de facto lost much of its independence, adding that clearly it is
driven by political motives given Sanusis vocal criticism of oil revenue leakages and the
opaque fiscal system in Nigeria. Strictly speaking, the President cant remove the head of
the central bank, which is perhaps why this is a suspension rather than an outright sacking;
that would require a two-thirds vote in the Senate.
These are not good times for the MINTs, the newly-coined agglomeration of emerging
economies below the BRICs. Indonesia and Turkey are suffering with their deficits and
currencies; now Nigeria is in the mire again. Lets hope Mexico can stay steady on its own
reform agenda so that at least one of the four has a good year.
Pros and Cons of Investment Professionals
On 10/13/2010, In Mutual Funds, By Jordan Wilson
I believe that non-professional investors should not normally compete with professionals.
In some ways, I view it as competing against Tiger Woods on the golf course. Unless you have
the same skills, it is difficult.
The professionals have an unfair advantage over the amateurs and it is not wise to try and beat
them in picking investments.
Two Types of Investment Professionals
I shall quickly differentiate between two types of investment professionals.
The first is the mutual fund manager. That is the person who makes the investment decisions on
behalf of the fund.
The second is the research analyst. That is the person who prepares the buy and sell
recommendations on specific investments.
There are other investment professionals including individuals who invest for their own
livelihood. But for discussion purposes here, we will focus on fund managers and analysts.
Advantages of Investment Professionals
Investment Skills and Experience
It is not a simple process to pick individual stocks, bonds, or other investments. Fundamental
analysis requires strong quantifiable skills and an understanding of the business, industry, and
economic conditions to properly assess the qualifiable considerations.
Professional fund managers and analysts should have the financial skills and experience to
conduct better investment analysis than the average investor.
Better Information and Tools
Investment professional likely have access to better analytical tools and data than you or I.
They also have better access to the corporations that they follow. This includes access to a
companys investor relations staff or management as well as to special conference calls that
companies conduct for investors.
These two areas make life difficult for investors such as myself. I would be considered an
investment professional given my technical qualifications and experience. But having less timely
access to corporate information and other relevant data puts me at a disadvantage to a financial
analyst in a large firm or mutual fund. While I may not mind playing Tiger Woods for money, I
want to make sure that I am not using golf clubs from the 1950s when I do so.
I would also add that funds with significant investments in companies are often able to shift a
companys business agenda. This is usually done at shareholder meetings where funds hold
enough shares to pressure companies to follow strategies that the funds prefer.
Its Their Job
Another problem for most individuals is that they are not full-time investors. Fund managers and
financial analysts spend their days researching investments. That is their job.
Some of you are students. Others are lawyers, doctors, dentists, plumbers, government
employees, and so on. Whatever you do, you put in a full week at your own job. Any time for
investing comes at night or on the weekends.
If you had the time and the tools, you might be better able to compete with the professionals. But
you do not. This also puts you at a competitive disadvantage.
Disadvantages of Investment Professionals
There are a few potential disadvantages to using fund managers or analyst recommendations
when investing. I will expand on a couple of these points in subsequent posts.
Some Professionals are Better than Others
As should be expected, some research analysts and fund managers are better than others.
The trick is to find the good ones and to avoid the poor.
Not always a simple thing to do.
Reviews of peer group performance and category ranking is the main way to assess relative
performance.
Does Active Management Work?
There is great debate as to whether analysts or fund managers can out-perform their relevant
benchmarks.
In some select instances, I believe it is possible. But for the most part, I am doubtful as to
whether active management can beat a passive approach to investing.
We will look at the arguments for and against active management later in some detail.
Neglected Market Segments
Professional investors focus on specific market segments. The segment may relate to their area
of expertise (e.g. an oil and gas analyst would focus on oil and gas companies) or investment
style (e.g. a Swiss large-cap equity fund would analyze the relevant Swiss companies).
Often there are neglected market segments that analysts do not follow and/or funds do not invest
in.
These may be extremely small segments such as micro-cap mining companies in Australia. Or
they may be markets where information is scarce so that analysts and managers do not follow the
segment closely. Equity investments in Iraq might be a good example. Or perhaps the local
market is relatively inefficient and analysts/fund managers cannot match the local expertise. For
example, a New York based real estate analyst trying to assess the residential real estate in
Tucson, Arizona.
In neglected or inefficient markets, small investors, especially those with specialized knowledge
of the market segment, can out-perform the investment professional.
An amateur investor with sophisticated knowledge in 18th Century art may be equally skilled
against professional investors who trade in fine art. Or a geologist working in Calgary, Canada
and deals with small oil and gas companies on a daily basis may have an advantage over a
professional investor who lacks the local knowledge and contacts.
Fund Management Fees
Like anything in life, if you want a service you must pay for it.
For every dollar spent on management fees, that is one less dollar of performance. And one less
dollar that can be reinvested to compound over time.
We have previously reviewed costs and seen that management fees can be a significant
component in a mutual funds expenses.
Not surprisingly, management fees can be a relative concept.
Top fund managers command greater compensation levels which impacts fund performance. Is it
better to choose a fund without a star manager? You may forego potentially better future returns
but you will certainly save money on fees.
Or what about funds that require greater amounts of work by the managers. Investing in
developing markets typically requires more work (i.e. management time and other costs) than in
developed nations. Is it better to pay greater fees and expenses for access to these markets?
Do the Advantages Outweigh the Disadvantages?
I do not think that the typical investor should compete against the professionals. And by
competing, I refer to the selecting of individual securities and other assets.
The typical investor lacks the technical skills, investment and economic experience, and time to
be a professional investor.
Unless you have specialized expertise or access to better information in an inefficient or
neglected market segment, I suggest avoiding selecting specific investments on your own.
That said, do the costs and performance achieved through active management make the use of
professionals a wise move?
I shall save that assessment until after our deeper look at relative manager performance; against
ones peers and the benchmark.
Fund Manager
A A A
Filed Under: Hedge Funds, Mutual Funds

Definition of 'Fund Manager'

The person(s) resposible for implementing a fund's investing strategy and
managing its portfolio trading activities. A fund can be managed by one
person, by two people as co-managers and by a team of three or more
people. Fund managers are paid a fee for their work, which is a percentage
of the fund's average assets under management.

Also known as an "investment manager".

Investopedia explains 'Fund Manager'

The individuals involved in fund management (mutual, pension, trust funds
or hedge funds) must have a high level of educational and professional
credentials and appropriate investment managerial experience to qualify
for this position. Investors should look for long-term, consistent fund
performance with a fund manager whose tenure with the fund matches its
performance time period.

The whole point of investing in a fund is to leave the investment
management function to the professionals. Therefore, the quality of the
fund manager is one of the key factors to consider when analyzing the
investment quality of any particular fund.
Competitive advantages
It is not just our years of experience and history of innovation that have helped to make us one of the UKs top investment
managers. Weve identified the three core competencies that we feel set us apart from our competitors:
History of firsts
M&G Investments timeline
How do we promote the long-term wealth of our investors?
Our approach and philosophy
Our specialised teams
Our fund managers dont simply follow the latest investment trends. Instead, they each have their own individual
and rigorous approach, through which they seek to optimise the performance of their funds.
The courage to act on our convictions
We strongly believe that actively managed funds have the potential to outperform passively managed funds, thereby
generating the best returns for investors over the long term. Backed by the resources our size and scale can offer, our
fund managers are free to develop their own individual investment strategies.
This allows them to act on their convictions without being constrained by a rigid house style.
Expertise in active management
There are two main types of asset manager: a passive fund manager will track a market's performance by investing
proportionately in the companies that make up a representative index*, whereas an active manager will actively
select stocks for their funds, depending on their views of future economic, market and company performance.
Anticipating market trends is one of the main factors differentiating active investment managers from passive
managers. At M&G, we believe that, no matter what the prevailing economic conditions, there are always
opportunities to be found for the investor who knows where to look.
* An index represents a particular market or a portion of it, serving as a performance indicator for that market.
The value of stockmarket investments will fluctuate, which will cause fund prices to fall as well as rise and you may
not get back the original amount you invested.
Should I fire my underperforming fund manager?
By: Joanna Faith
24 Feb 2014
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A study published today revealed that UK investors have ploughed nearly 35bn into underperforming funds.
The list of culprits - published by Chelsea Financial Services - highlighted poor performance from heavyweights
Fidelity, Legal & General, and SWIP.
Reading that their fund has underperformed can seriously test the faith and patience of an investor but it does not
necessarily mean it is time to sell-out.
There are a number of reasons funds underperform and identifying the cause should be the first step taken by
worried investors.
Why do funds underperform?
The main reason for a fund to underperform is if the manager's style is out of favour with the market.
For example, Tom Dobell, manager of the M&G Recovery fund, a long-time investor favourite, struggled with a period
of underperformance compared to his peers.
However, much of his underperformance was attributed to the fact that his style was out of favour.
"Investing in undervalued companies means he has a long holding period before he realises value from his
investments," says Adrian Lowcock, senior investment manager at Hargreaves Lansdown.
"In recent years this has taken longer as a lack of M&A [merger and acquisition] activity has not provided an exit for
some of his investments. This means the holding period on his investments lasts longer than is normal. However his
approach will come back in favour, investors just need to be patient."
Invesco Perpetual's Neil Woodford and Fidelity's Anthony Bolton are two further examples of top fund managers who
have experienced dips in performance throughout their careers. Again, this at times was down to their style.
"They are contrarian or value managers so are looking for investments whose full value is not appreciated by the
market. It can be very lonely being a contrarian and investors need to be patient which is tough," Lowcock says.
Of course, some times the manager is entirely at fault. They could have made bad stock picks, miss-timed the market
or simply got their asset allocation wrong if they run a more diversified fund.
Currencies can also play a negative role in the performance of a non-UK fund.
Time to jump ship?
Darius McDermott, managing director of Chelsea Financial Services, says investors should consider a number of
factors before ditching a poor performing fund.
First, he suggests asking the manager to explain the underperformance: "If the manager can't articulate why, to me
this is a warning sign. If the manager can explain the underperformance and how they think it may turn around in the
future, and the investor is happy with the explanation, they may decide to stick with the fund."
He also believes investors should consider the longevity of the manager: "I'd give a more experienced manager with
a track record more breathing space if they had a year or two of underperformance than I would a new manager who
has only been investing for three years, for example."
Lowcock, meanwhile, suggests investors ask themselves whether the manager is actually underperforming.
"Check against the right benchmark," he says.
"For example, a manager only investing in FTSE 100 companies will have looked bad for the past decade compared
to the FTSE All Share but this is not a fair comparison. Also check how their peers have done. Look at sector peers
as well as those with a similar investment style. If the environment has changed have they adapted to it the other
manager not?"
Extracts of this article were first published on YourMoney.com in October 2013.