Tuesday, May 31, 2011

The Four Causes of the Financial Crisis

Noman is delivering a paper at a Business Ethics conference next week, and appends his abstract for your consideration:
The lessons learned from the financial crisis depend on the causes identified, which in turn will affect the steps taken to prevent another such crisis from occurring.  

In the US, the President’s Financial Crisis Inquiry Commission released its findings in January of 2011.   Rather unusually, significant financial reform passed the Democratic controlled Congress in 2009 (the Dodd-Frank Act), well in advance of considering the conclusions reached by the very commission appointed to study the causes and suggest appropriate reforms.  

Thus, unlike the Pecora commission report, which led to the bipartisan adoption of the Securities Act of 1933, the Securities Exchange Act of 1934 and five other significant pieces of legislation over the ensuing seven years, the FCIC report was controversial, controverted, and politically irrelevant other than as an exercise in post hoc legislatory justification.  Financial reform passed with scant support from the opposition party.

The report featured a majority opinion reflecting the opinions of six Democrats on a commission of ten.  Three Republican commissioners dissented from the majority opinion.  A fourth Republican commissioner filed a solo dissent.  This latter commissioner’s findings have been widely dismissed as the “conservative critique,” which was explicitly rejected in the majority report.

This paper explores the various reasons for the financial crisis proposed by various commissioners and other parties, and orders them according to an Aristotelian typology of four causes: material, formal, efficient and final.  All are “causes” of the financial crisis. 

 The material cause is “that out of which” the crisis occurred.  The simple and relatively non-controversial answer to that question is “sub-prime mortgages.” 

The formal cause is “that into which” the material was formed.  Again, the answer is widely acknowledged: the securitizations and “insurance” contracts of structured finance: ABS’s, RMBS’s, CDO’s, and CDS’s to name just a few of the more significant ones.  Once detonated on the balance sheets of highly leveraged financial institutions, this toxic mix ignited a meltdown of the financial system. 

The efficient cause is “that by which” the crisis was brought about.  The trigger of the crisis was the Federal Reserve policy of rising interest rates between 2004 and 2006.  

Chairman Greenspan’s easy money policy of the 2002-2004 is widely blamed for inflating the housing bubble.  But, the trillions of dollars of securitized and insured subprime mortgages with rate resets were the dynamite that exploded bringing down the proverbial house.  Sub-prime mortgages blew up precisely because of teaser rate originations with variable rate resets that skyrocketed 4-5% in just a couple of years due to Fed policy.

This was the handiwork of Chairman Bernanke.  Federal Reserve policy also had the affect of dampening housing prices, which triggered speculator’s defaults.

The final cause is “that for the sake of which” the crisis happened, “that without which” it couldn’t have happened.   This is the controversial cause, the one that government and media have been loathe to acknowledge.  This cause, persistently identified, and consistently predicted by commissioner Peter Wallison as early as the year 2000, is the US government’s “affordable housing” policy.  

Affordable housing goals were given to the government-sponsored entities (GSE’s), Fannie Mae and Freddie Mac, which were instructed by the U.S. Department of Housing and Urban Development (HUD) to purchase up to 42% of their multi-trillion dollar portfolios in sub-prime mortgages for package and resale to pension funds, insurance companies, financial institutions, and foreign entities—with a government (i.e., US taxpayer) guarantee. 

On other fronts, the U.S. Department of Justice and community-organizing associations (e.g., ACORN) sued banks into lowering lending standards, and making loans to communities that were traditionally poor lending risks, that is, not likely to pay them back.  The overall affect was a dramatic and marked decline in lending standards, which opened the floodgates to the subprime mortgage deluge that swamped the global economy in 2007 and 2008.

All are causes of the financial crisis of ’08.  Ironically, the critique of the Wallison position as “conservative” is apt, but for the wrong reason.  One doesn’t have to be a conservative Republican to see that US government policy from the 1970’s to the crash coerced lending decisions in ways that proved, in retrospect, to be extremely unfortunate.   (Indeed, given legislative initiatives in DC, one is tempted to say that one would have to be a liberal Democrat not to see it.)  

However, this view is essentially conservative not for modern political reasons, but because it addresses the final cause of the crisis, and final causes have been all but banished from occidental intellectual inquiry since Francis Bacon in the seventeenth century.  It is precisely a notion of reality that rests on metaphysical foundations rather than materialist empiricism or subjective volition that people labeled as conservatives are often trying to “conserve.”  

What Wallison’s analysis of the financial crisis, and the widespread dismissal of his critique—or rather, its general failure to resonate with the populace—might indicate, is the inability of society to see what it has generally ceased to look for.  

This is highly problematic for society if final causes do indeed matter.  This author is afraid that time will tell, and what it tells us won’t be good.

Note that acknowledgement of a final cause, is not a rejection of any analysis that points to the material, formal or efficient causes.  Indeed, a “conservative” critique acknowledges the other causes, while it insists on reform of all four of the crisis’s causes, not just the politically expedient ones.  

In the author’s opinion, to reform the other causes without touching the final cause—embodied in the GSE’s “affordable housing mandate”—is a prescription for disaster.   Ironically, this is precisely what has happened in the US, though discussions to reform the GSE’s are presently underway in Congress.  They were exempted from Dodd-Frank.

Does anyone really believe that government will preserve us from financial crisis when it cannot acknowledge its own role in fostering it?

Noman is expecting to be widely assailed by big named tenured professors (and their untenured toadies) from American and European universities.  In twenty years of academic life, Noman has rarely seen anything as belligerently narrow-minded as a progressive, liberal professor.  Unfortunately, that is the dominant academic breed, which tenure ensures.

In a trial run of this presentation for executives last week in Vienna, the only American in the audience reacted in agitation at Noman's "overt politicization" of the topic.  He blamed the entire crisis on Ronald Reagan and his free-market ideology.  This "non-political" critique is the Barney Frank, official Democratic party line, which was nicely captured in the widely-praised movie, "Inside Job."

Noman doesn't buy it.  Or, rather, he buys it only up to a point, which, incidentally, is not a reasonabe starting point for financial reform.

Now you know some of what's been keeping Noman from posting.

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