Monday, January 4, 2010

Fundamental Causes of the Financial Crisis

As I've learned recently, capital requirements (as in Tier I capital, etc.) are the only limit to lending by banks. But the use of SIVs and off balance sheet subsidiaries allowed banks to escape the capital requirements imposed on them. Even without the SIVs, a "well-capitalized" bank only needs a tier 1 ratio of around 8%!

The capital requirement for Fannie, and other GSEs were even lower at around 3%. Back in 2002-4 when Fannie had an accounting scandal, Congress had a chance to reform and limit the outrageous size of the GSEs, but of course this was defeated. Meanwhile Bush pushed for lower down payment requirements and government subsidies to make housing "affordable for all".

The crisis is almost totally due to bad loans, or loans that are underwater. Had the standard 20% down payment been in place, it would have been hard for the majority of the populace to engage in the bubble. Bubbles can only happen when the mainstream populace participates. The 20% equity would have also cushioned the banks from the majority of losses in my opinion as the peak would have been lower to begin with.

Interestingly enough, we're not the only ones with a housing induced crisis. Australia and Spain are only some of the many other nations that similarly experienced a housing bubble. This leads me to the belief that there is a systematic problem within the global financial network. The problem is that bank lending is not constrained adequately. Furthermore, the low interest rate environment does NOT translate into commodity or consumer good inflation thanks to what the modern financial system has developed into, which is a credit based system.

In this new system, firms or agents first identify an investment opportunity (it can be to build a factory or buy an income producing asset that will generate a greater return than the cost of the loan). Banks then lend to the firm or agent. Notice that the identification of the investment opportunity is step number one, not the lending. With a low interest rate environment, the hurdle to clear for a profitable investment is much lower. Borrowers then borrow to acquire assets. I believe this is why we saw asset and commodity inflation but no inflation in goods and services tracked by the CPI. Firms and agents aren't borrowing to consume, they are borrowing to acquire income assets or building a factory (or store) that produces consumer goods and services to sell at a profit. The new production that comes online keeps prices for consumer goods and services down, but the means of production get bid up. The lower the interest rate, the lower the threshold yield needed for a firm or agent to borrow to acquire or build.

I don't think people understand this new system of finance. This is why people are constantly looking for inflation (as measured by CPI) but finding none except in asset prices (which aren't included in CPI) and can't see the connection between the FED's loose monetary policy and the various bubbles (all asset bubbles) that have popped up. In sum, I identify lax leverage limits and the low interest rate environment established by the various central banks as the underlying causes of the crisis.

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