U.S. subprime crisis 2: causes

The crisis can be attributed to a number of factors pervasive in both housing and credit markets, factors which emerged over a number of years. Causes proposed include the inability of homeowners to make their mortgage payments (due primarily to adjustable-rate mortgages resetting, borrowers overextending, predatory lending, and speculation), overbuilding during the boom period, risky mortgage products, increased power of mortgage originators, high personal and corporate debt levels, financial products that distributed and perhaps concealed the risk of mortgage default, bad monetary and housing policies, international trade imbalances, and inappropriate government regulation.  Excessive consumer housing debt was in turn caused by the mortgage-backed security, credit default swap, and collateralized debt obligation sub-sectors of the financial industry, which were offering irrationally low interest rates and irrationally high levels of approval to subprime mortgage consumers because they were calculating aggregate risk using Gaussian copula formulas that strictly assumed the independence of individual component mortgages, when in fact the credit-worthiness almost every new subprime mortgage was highly correlated with that of any other because of linkages through consumer spending levels which fell sharply when property values began to fall during the initial wave of mortgage defaults. Debt consumers were acting in their rational self-interest, because they were unable to audit the finance industry's opaque faulty risk pricing methodology.

Among the important catalysts of the subprime crisis were the influx of money from the private sector, the banks entering into the mortgage bond market, government policies aimed at expanding home ownership, speculation by many home buyers, and the predatory lending practices of the the mortgage lenders, specifically the adjustable-rate mortgage, 2-28 loan, that mortgage lenders sold directly or indirectly via mortgage brokers. On Wall Street and in the financial industry, moral hazard lay at the core of many of the causes.

In its "Declaration of the Summit on Financial Markets and the World Economy," dated 15 November 2008, leaders of the Group of 20 cited the following causes:

During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.

Federal Reserve chair Ben Bernanke testified in September 2010 regarding the causes of the crisis. He wrote that there were shocks or triggers (i.e., particular events that touched off the crisis) and vulnerabilities (i.e., structural weaknesses in the financial system, regulation and supervision) that amplified the shocks. Examples of triggers included: loses on subprime mortgage securities that began in 2007 and a run on the shadow banking system that began in mid-2007, which adversely affected the functioning of money markets. Examples of vulnerabilities in the private sector included: financial institution dependence on unstable sources of short-term funding such as repurchase agreements or Repos; deficiencies in corporate risk management; excessive use of leverage (borrowing to invest); and inappropriate usage of derivatives as a tool for taking excessive risks. Examples of vulnerabilities in the public sector included: statutory gaps and conflicts between regulators; ineffective use of regulatory authority; and ineffective crisis management capabilities. Bernanke also discussed "Too big to fail" institutions, monetary policy, and trade deficits.

During May 2010, Warren Buffett and Paul Volcker separately described questionable assumptions or judgments underlying the U.S. financial and economic system that contributed to the crisis. These assumptions included: 1) Housing prices would not fall dramatically; 2) Free and open financial markets supported by sophisticated financial engineering would most effectively support market efficiency and stability, directing funds to the most profitable and productive uses; 3) Concepts embedded in mathematics and physics could be directly adapted to markets, in the form of various financial models used to evaluate credit risk; 4) Economic imbalances, such as large trade deficits and low savings rates indicative of over-consumption, were sustainable; and 5) Stronger regulation of the shadow banking system and derivatives markets was not needed.

The U.S. Financial Crisis Inquiry Commission reported its findings in January 2011. It concluded that "the crisis was avoidable and was caused by: Widespread failures in financial regulation, including the Federal Reserve's failure to stem the tide of toxic mortgages; Dramatic breakdowns in corporate governance including too many financial firms acting recklessly and taking on too much risk; An explosive mix of excessive borrowing and risk by households and Wall Street that put the financial system on a collision course with crisis; Key policy makers ill prepared for the crisis, lacking a full understanding of the financial system they oversaw; and systemic breaches in accountability and ethics at all levels."

Sources:

http://en.wikipedia.org/wiki/Subprime_mortgage_crisis#Causes