According to newspapers, the Panic of 2008 was the worst financial crisis since the Great Depression. In an attempt to deal with the crisis, the government proposed a $700 billion bailout plan that was in addition to lending as much as $85 billion to American International Group (AIG), the insurance giant. In the midst of all this, the Fed approved Goldman Sachs Group Inc. and Morgan Stanley to become bank-holding companies. In the process, the Fed provided them with liquidity support by extending credit to their US broker-dealer subsidiaries. If we add the Fannie and Freddie intervention, the liquidation of Bear Stearns, and the failure of Lehman Brothers, it is easy to see why people consider the Panic of 2008 the most severe crisis since the Great Depression. So the question facing us is whether the crisis was a bad outcome or the result of choices induced by bad policies? Clearly the answer does not need to be a binary one. It is possible that there is some bad luck involved as well as some bad choices. As analysts, we now need to pause and apportion the effect on the recent market fluctuations to each of these two possibilities. Only then can we come up with a long-term solution that increases the chance of economic success in the long run.

At the time of the crisis, both presidential candidates called for more regulations, as did many legislators. In effect they were saying that lack of regulation led to the crisis. But as we argue below, that is not necessarily the case. This brings a warning regarding legislators. As the saying goes, legislators legislate. As one reviews many of the arguments in favor of more regulations, counterarguments emerge suggesting that people who argue for the lack of regulation and/or regulatory oversight may be overstating their case. Let’s take the case of lack of regulation. As the Wall Street Journal pointed out at the time, the less-regulated entities did not get in as much trouble as the regulated ones. The hedge funds and private equity vehicles fared much better than the investment banks, but more on the regulations later.

The central bank and “easy” monetary and credit policies were blamed as a major cause for the crisis. The origin of the easy policy goes back to the famous “Greenspan Put,” when the Fed lowered short-term interest rates as low as 1% for a “considerable time.” This created a one-sided bet. With long-term rates well above the 1% range, institutions had an incentive to borrow short and buy long, thereby making the spread. Levering the position would increase the profits from the spread. So an extension of this argument is that the Greenspan Put and the Fed’s easy money policy fostered and condoned an increase in the leverage of the banking and financial system. So far, we agree with the argument.

In our opinion, a major and perhaps the main culprits of the current crisis were the Government-sponsored Enterprises (GSE), and Fannie Mae and Freddie Mac. Much like Savings and Loans (S&Ls), Fannie and Freddie were in the business of financing residential real estate. However there were some clear differences between S&Ls and the GSEs. Fannie and Freddie had no depositors and as a result there was no danger of them suffering a run on the bank. Another difference between S&Ls and Fannie and Freddie were the lower capital requirements on GSEs. The statutory minimum capital level for a GSE is 2.5% of the aggregate balance sheet assets and 0.45% of the off-balance sheet assets. These capital requirements afforded the GSE a higher degree of leverage than S&Ls, thereby increasing the GSEs sensitivity to interest rate risk.

So far we have focused on the supply side of the equation, the provision of credit/loans. Now let’s focus on the demand side, in particular the demand for residential real estate loans. It is commonly argued that the Fed’s easy credit or Greenspan Put fueled the residential real estate market. However, that is not the only reason for the increase in the demand for real estate. Going back to 1997, a change in the treatment of real estate may have something to do with the housing boom. The new law exempted, for married couples, the first $500,000 worth of capital gains every two years. Excess capital gains would now be taxed at the lower 15% rate, while the imputed income from living in owner-occupied housing would not be subject to tax. Add to this the deductibility of interest income and one can see why real estate would become hugely tax advantaged. The tax story, while complementary to the credit story, adds to the explanation as to why real estate demand increased substantially. In turn, the higher real estate volume led to an increase in the demand for real estate loans.

The past couple of decade’s development in finance led to what many called advances in financial economics. Some of the innovations were significant and led to many applications. On the positive side, we point to securitization. However, not all the innovations are without cost.

Absent credit markets, people’s spending is constrained by their current income. However, as markets expand, people may be able to smooth their consumption by borrowing during low-income years and repaying the loans during high-income years. A major benefit of the financial developments of the past three decades is our increasing understanding of risk considerations. The progress made has been phenomenal. People have been able to effectively securitize anything and as a result they no longer need to be constrained by their current income, instead they are constrained by their net worth. Income only matters in so far as the net present value of income is a key component of a borrower’s net worth. As long as a borrower can service its debt, he or she will lend up to a high fraction of his or her net worth. In technical terms, the consumer instead of facing a series of one-year income constraints, now faces a lifetime wealth constraint. Since the need to borrow is higher during low-income years, one can easily show that the wealth constraint leads to higher debt levels (i.e., increased leverage ratio). This was a major development and it created a new set of issues as wealth is constantly changing. Lenders have to take steps to insure repayment. In addition to debt service ratios, lenders began to use more frequently measures such as loan to net worth ratios. The focus on net worth leads to higher loans and higher level of debts on the part of the consumer which, in turn, leads to a greater emphasis on measures designed to insure that there is enough equity backing the loans in addition to the traditional measures insuring that the borrower would have enough income to service the debt.

The impact of changes in wealth may not be symmetrical. It is possible that as wealth changes so will the lending standards and the loan to value ratio could very well change with the level of wealth. In short, fluctuations in wealth lead to exaggerated fluctuations in credit creation. But that is only half of the story. Lenders have rules and regulations regarding loan to value ratios which we call capital adequacy ratios. If you think of conforming loans by the GSEs as analogous to a bank reserve requirement (i.e., 20% down on any loan amount), we can argue then that the GSEs effectively circumvented their reserve requirement even though they deluded themselves into believing that they were replicating the same risk profile by buying insurance against default and implementing an interest risk management program. The results show that they failed. How can that be with so many rocket scientists around? Our answer is that they made the same mistake that other high-powered financial institutions like Long-Term Capital Management (LTCM) made in the past. It is a mistake to take as a God-given truth the correlations among different instruments. We have written in the past that these correlations are not invariant of the economic environment and when they change so does the risk profile. To be truly safe, these institutions would also have to forecast the variance covariance of all instruments. This is something that they either take for granted or are not very good at forecasting. Finally, it is the lack of understanding of these correlations that produces the opaqueness in the system. On the downside, this dynamic could be troublesome. The decline in values could trigger additional restrictions on credit creation and the well-functioning of the system. If you have doubts about the viability of the counterparty, why trade with them or why have your money there? The lack of confidence, in effect, generates a run on the bank so to speak. The past few weeks are a clear reminder of this situation.

It is apparent that an increase in capital is needed to restore the confidence in the system, as well as the credit creation ability. The Fed had tried to do this in a variety of ways. Institutions under its jurisdiction are subject to capital adequacy ratios and reserve requirements. Shortages of capital and/or reserves as assets are marked-to-market and cause a credit contraction. During the crisis, the Fed in effect injected capital by allowing institutions to borrow at face value against assets whose market value is, in effect, lower. The difference between the face value and the market value represented the additional injections of reserves. However, as long as mark-to-market accounting was in effect, the value of the nonpledged assets would also affect the capital adequacy ratio and in a downdraft we know the direction of the impact on credit. That in turn triggers additional pledging until either all assets are pledged at which point the Fed would effectively control the banks or until the market recovers and asset prices begin to rise. But even in this case, the institutions are not out of the woods. As long as asset values are below the amount at which the Fed values them, these institutions will not be able to expand their activities unless they get additional capital.

One way to restore confidence in the financial system during a financial crisis as that of 2007–08 is that regulators have to find a way to isolate these assets, to reassure the economic agents that a decline in the value of these assets will not trigger additional credit contraction or capital deficiencies. Here we can learn something from the hedge fund industry. In the parlance of the hedge fund industry, they need to create a side pocket. That is what the government did during the S&L crisis of the 1990s when it created the Resolution Trust Corporation or RTC.