What we now know

By Allister Heath, April 8, 2010

If most commentators were to be believed, the causes of the financial crisis were straightforward: it was all about greed, stupidity and even corruption. But as economists continue to study what really happened, it is becoming increasingly clear that the forces that caused the irrational exuberance and stupid decisions of the bubble years were far more complex than usually understood.

We all know that US and European banks lost billions because they invested in Collateralised Debt Obligations (CDOs), those infamous packets of sub-prime mortgages that everybody thought were safe but which suddenly started to lose their value in 2007, destroying the financial system in the process. Yet what nobody realises is that an obscure yet crucial piece of US regulation actually encouraged US retail banks to buy CDOs and to shun more traditional, safer assets.

The best explanation is to be found in a brilliant book edited by Jeffrey Friedman entitled The Causes of the Financial Crisis, to be published in December by University of Pennsylvania Press.

US retail banks were required to retain just $2 in capital for every $100 invested in AAA or AA-rated CDOs, compared to $5 for the same amount in actual mortgage loans and $10 in commercial loans. The so-called "recourse rule" - pushed through by the Fed and other regulators - was deliberately designed to steer banks' funds into CDOs. It succeeded: the banks gorged on them; as far as they were concerned, they were merely following the new best practice. The US authorities were therefore not only complicit but also directly responsible for the destruction of the US banking system. Their rule also helped inflate the demand for CDOs, securitisation and even sub-prime mortgages, especially when Wall Street had run out of mainstream mortgages to bundle up.

Friedman's scintillating analysis also remind us that the financial crisis was not directly caused by mortgage defaults - banks could have coped with that. Rather, it was triggered by a collapse in the market price of CDOs caused by fears about the effect of declining house prices, a much more devastating and uncontrollable phenomenon. It was this which decimated balance sheets - not mortgage defaults per se. Had the regulatory system not encouraged retail banks to hold securitised bundles of hard-to-value, opaque CDOs, rather than stick with mortgages themselves, the crisis might have been avoided or at least it would have been much less severe.

The more one studies what really happened in 2007-09, the more it becomes apparent that regulatory failure was a key driving force in the excesses of the bubble years. Not only did regulators fail to stop the rot, they actually encouraged it.

Allister Heath is editor of City A.M.

Last updated: 11:02am, April 8 2010