Millennium Post

What burst the bubble

Analysing root causes of the 2008 financial crisis using tools of New Institutional Economics

While recessions are not new and mostly involve the financial sector, policymakers don't seem to learn the right lessons. In particular, the neoclassical model, in my view, does not apply to the financial markets. Financial markets do not 'clear' on their own but require substantial regulation. And yet, in the run-up to the financial crisis of 2008, we got responses such as the 'Greenspan Put' and 'irrational exuberance'. The Great Depression of the 1930s should have settled the matter but economists such as Eugene Fama of the Chicago School continued with models which concluded that markets are rational and efficient and self-regulate, rather than requiring any intervention.

Research in New Institutional Economics can provide insights into financial crises. In this article, we will see how serial principal-agent problems lead to moral hazard because of asymmetric information. We will focus on the 2008 crisis. We will see how traders and investment bankers, created toxic securities such as CDO (Collateralized Debt Obligations), CDO², (CDOs of CDOs) and CDO³ and so on. CDOs, as we know, are basically financial securities which are formed by pooling together various loans such as auto loans, home loans, credit card loan etc. These CDOs are then sold to other investors by the banks.

The 2008 Crisis

The financial crisis of 2008 is still fresh in our minds and many countries are still working to overcome the recessionary effects of the crisis. However, the 2008 crisis was hardly one of a kind and many crises in the past had a similar genesis. Nouriel Roubini, the NYU economist has reminded us that crises such as the speculative bubble in tulips in 1630 in Holland or the Great Depression of the 1930s had a similar genesis as the 2008 crisis. They had the same elements: a boom, followed by speculation in an asset class (tulips in 1630, Housing in 2008), creation of a bubble and the bursting of the bubble. Roubini says that all such crises are hardly 'Black Swans' – instead, they follow a predictable path and corrective action should be taken as soon as tell-tale signs appear.

The Glass – Steagall Act 1933

Arguably, the financial crisis in developed countries began with the repeal in 1999 of the 'Glass – Steagall Act of 1933'. Recall that the 1933 Act had separated commercial and investment banking in response to the banking crisis of 1933. There was a felt need to separate the business of deposit-taking and leading (to be carried out by commercial banks) from the business of underwriting and issuing securities (to be carried out by investment banks). Clearly the lessons of 1933 were forgotten and in 1999, the Act was repealed after hectic lobbying from investment banks. The repeal took the US financial system back to the pre-1933 days and bankers and brokers again became indistinguishable. As a result, investment banks began to accept deposits as well as trade-in securities such as collateralised debt obligations and mortgage-backed securities. Even after the recent 2008 crisis, one continues to see lobbying efforts to keep investment banking far away from the regulatory embrace of the Federal Reserve or the Security and Exchange Commission in the US. We may recall that the Federal Reserve under the chairmanship of Alan Greenspan not only agreed to the logic forwarded by the investment banks but also encouraged such logic by stating that regulation of these banks would stifle financial innovation and hence, would lead to squeeze in the credit and financial markets. Later, Ben Bernanke, the Federal Reserve Chairman, intervened aggressively to douse the fires and injected massive liquidity into the system. However, by the time Bernanke finished, the financial system looked very different-the Federal Reserve had become an active player in the financial markets, rather than being the lender of the last resort. Although Lehmann Brothers was allowed to fail, the US had perhaps failed to hold the line on moral hazard. Let us see how the US reacted.

The US response

The Bush Administration in its final days in January 2009 put in place, the Troubled Assets Relief Programme (TARP), which proposed to purchase or insure up to $700 billion of 'troubled' assets. The Obama administration put forward a response on two fronts: a fiscal stimulus package worth $787 billion and a financial stability plan. The plan's objective was to purge banks of their toxic assets. The new element in the plan was that it created financial incentives for players in the private sector to buy up the troubled assets. The basic idea was to lend government money through the Federal Reserve (or guarantee borrowings via FDIC) at a suitable spread over Libor to anyone willing to buy toxic assets from the banks.

The situation had become so dire that there were calls from even ardent free-market proponents, to nationalise the financial sector. These programs not only bailed out the large investment banks (Citicorp, Goldman Sachs, JP Morgan, Wells Fargo etc.) but also auto companies such as General Motors. The Federal Reserve also threw credit lines to anyone and everyone requiring and asking for one.

Deciphering the crisis: insights from New Institutional Economics

We may recall that the case for supplying public goods such as financial regulation arises from market failures. Market failures, in turn, are caused mainly by externalities, information asymmetry and monopolies. Particularly, in the case of the financial sector, it would be evident from the discussion above that information asymmetry was the primary reason for the markets to have collapsed and the widespread financial crisis. However, an added feature was that even the Government failed which is evident from the inaction by the Federal Reserve in the United States in the run-up to the 2008 crisis. It is another story that ultimately it was through strong Government intervention, with the various steps taken by the US Federal Reserve, that the recession was avoided.

Ever since the seminal works of Akerlof (The Market for Lemons in 1970) and later by Williamson, the importance of information asymmetry as a reason for market failure is well established. In the financial crisis of 2008, the asymmetric information was inherent in the various principal-agent situations that pervaded the financial system in the US. Some of the classic principal-agent relationships were: Shareholder and Banker/Trader; Shareholder and Institutional Finance such as Pension funds; Federal Reserve and Bank management and the Government and the Federal Reserve.

In the run-up to the 2008 crisis, the interests of shareholders of the various investment banks diverged from those of bankers/traders. This was basically because of the different time horizon of shareholders on one hand and traders and bank managers on the other. While the shareholders generally had a long time horizon in view, the traders and bankers pushed for more lending and transactions in the short run leading to highly leveraged banks. This was simply because more trades meant more bonuses.

Sometimes the shareholders would also sit back and let the traders and bank managers indulge in financial innovation that led to exotic and toxic financial products such as the CDOs mentioned above. This was because the shareholders knew that the Government will step in and prevent their collapse because they were too big to fail. This was precisely what happened with the major investment banks which were rescued in the aftermath of the 2008 crisis.

The crisis, therefore, had the following sequential steps: Mounting pressure on the bankers and traders to make profits and indulge in financial innovation; as a result, bankers and traders having to come up with exotic and toxic financial products such as CDOs which also had other names such as collateralised mortgage obligations and collateralised loan obligations. These were nothing but asset-backed securities but the asset being an opaque and unclear entity; this led to more lending even to those who had questionable repaying capacity. Also known as subprime lending; at some point, the subprime borrowers started defaulting on their mortgages which led to a devaluation of the security based on these subprime loans; next, many banks which were highly leveraged with such accounts on their books started cutting back operations. Many even collapsed and finally, spill-over from the financial sector to the real economy with contraction of credit flow and overall economic activity.

Early Warnings

It was not as if there were no warnings about the impending crisis. Nouriel Roubini, the NYU Professor referred to above, had warned in 2006 that corrective measures need to be taken since debt in the financial system was rising beyond manageable levels. Raghuram Rajan had also cautioned in 2005 that the compensation of bankers and traders needed to be rationalised so as not to incentivise them to take on too much risk and over-leverage the system. Nassim Nicholas Taleb (of the 'Black Swan' fame) had cautioned that financial markets were over-leveraged and many of the investment banks were under-regulated and would not be able to handle 'fat-tail' events.

Even with the warnings expressed above, the US Federal Reserve under Greenspan was a little late in reacting. In fact, the 'Greenspan Put' became well known whereby interest rates were kept low leading to growth in the stock markets. Investment banks were led to believe that low-interest rates would hold and therefore they could enter long positions and sell stocks at a higher price creating a 'Put' option. Greenspan was criticised for this policy since it encouraged risk-taking.

Solutions from the NIE Perspective

Lessons from New Institutional Economics would tell us that we need to address the root cause of asymmetric information. In this case, the root cause was perhaps principal-agent problem which led to excessively risky behaviour of the traders and bankers. This in turn was a result of excessive bonuses, irrespective of how the security performed in the market. To address this problem, some of the solutions suggested are Pooling of bonuses as proposed by Raghuram Rajan. Bonuses could be held in an escrow for 7 years and could be adjusted against traders' losses; traders' compensation being formed of the same security that they design and the Government stepping in to reform compensation, reform rating agencies and break up banks that are too big to fail or that are too inter-connected.

In the end, Hyman Minsky's work comes to mind. We may recall that Minsky had argued that instability originates in the very financial institutions that makes capitalism possible. While Minsky had made his comments in the 1980s, his ghost revisited us in the financial crisis of 2008.

The writer is an IAS officer, working as Principal Resident Commissioner, Government of West Bengal. Views expressed are strictly personal

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