The Real Causes of the Financial Crisis


In June of 2005, our cover story was, "Duck and Cover: How to protect your clients from the looming real estate crisis." And we further wrote this teaser for the article: "The real estate mania may be ending. What does that mean for advisors whose clients are heavily into REITs? And how does an advisor limit the potential damage for clients who have bought investment properties?”

Well, we all know how that turned out. We might have been early, but, let’s put it this way: A lot of people saw that housing prices were rising too quickly and that the Animal Spirits were completely out of control.

What many fail to see—particularly Democrats who want to demonize Wall Street and bankers—is the government’s role in this financial debacle of 2008 and 2009.

John A. Allison served as chairman and CEO of BB&T Corp. from 1989 to 2008, and was the longest-serving CEO of a top 25 financial institution. In short, Allison, who now leads the Cato Institute, a libertarian think tank, was in pole position to witness the causes of the financial crisis. In his new book, The Financial Crisis and the Free Market Cure, Allison writes: “The primary cause of the Great Recession was a massive misinvestment in residential real estate.”

We all know that. Allison’s point is, “Government incentives (which we will discuss) cause a massive reallocation of resources from savings (investment) to consumption (primarily in housing). . . . For a $3 trillion (or greater) misinvestment to occur, it takes government action. Private market are constantly making mistakes and then correcting. However, private markets will not make a mistake of this magnitude without significant incentives from government policy makers.

And then Allison goes on to list “primary sources of the massive misallocations of resources (both capital and labor).” They are 1.) The Federal Reserve, 2.) The Federal Deposit Insurance Corporation (FDIC), 3.) Government housing policy, primarily carried out by Fannie Mae (created in 1938) and Freddie Mac (created in 1970), the giant government-sponsored enterprises, and, 4.) The Securities and Exchange Commission.

In Chapter Three Allison begins his argument. And it is strong. I have not read the entire book yet, but as I make my way through, I will report back interesting quotations and arguments he makes. Allison says that the Fed, created in 1913, effectively “nationalized” the U.S.’s monetary system. “The federal government owns the monetary system. We do not have a private monetary system in the United States. Problems in the monetary system were the source of the current Great Recession. If there are problems in the monetary system, they are, by definition, caused by the federal government, because the federal government owne the monetary system.”

Like us (and many, many others), Allison says he and his bankers at BB&T—in 2005—began to grow worried by the speculative activity that they saw happening. And, BB&T, being considered local banks, its bankers living in the communities they worked in, had to take the delicate action of tightening up residential construction loans. “However the knowledge that government policy makers could act in an aggressive manner to save the house market made us significantly less willing to act to reduce risk than we would have been had the economy been a free market where we knew that market forces, not government action, would drive the results.”


Discuss this Blog Entry 5

on Dec 6, 2012

So, if I have an incentive, does it mean I should be greedy and irresponsible? I have an "incentive" to sell clients high commission products, but I don't. Certainly the gov't provided "incentives" for banks to lever up extensively (which the banks spent millions lobbying for), but to say that the gov't "caused" the crisis? Did the gov't put a gun to the bankers heads and make them write NINJA loans? Or, make the credit agencies like Moody's and S&P to rate bonds higher than they actually were? Or make Goldman create risky synthetic CDOs, sell them to their customers, then bet against the same CDOs that they knew were trash to begin with? What about Lehman and AIG? Allison calls these actions "mistakes"? Really?

on Dec 6, 2012

Very good points. But . . . the 1994 Boston Fed branch issued a paper (and since it regulates financial institutions, it counts!) about social engineering, whoops, giving mortgages to those who can't afford them, well, got the ball rolling. "Ownership society;" yeah, I know, that was Bush, but it was Clinton too, God bless him, who stared this whole liquidity flood. (Greenspan, especially. You remember the Greenspan Put?!)

Mr. msmith4012: Back to your point: gub'ment (say in your best Michigan militia accent!) does mess up the pricing mechanism of, well, residential real estate and other assets, financial and real assets. (Medical care, especially. My father was a physician. I used to be made to do the books. $9 for a kidney biopsy the gub'ment paid, $9 for a tongue depressor consultation. (Gub'ment didn't care). Gub'ment was stealing my father's labor and fixing prices, see also Soviet Union. Since we live in such a litigious society (everyone needs a lawyer now a'days), let's price fix the fees that lawyers may charge! "Punitive" damages should go to the Treasury, not the individual. Oh, almost forgot: Let's tax the "winnings" of a civil lawsuit. And loser pays.

Let's keep arguing! I thank you so much for your comment,

on Dec 7, 2012

What the gov't did was deregulate which is exactly what the bankers wanted, did they not? Yes, I remember Greenspan as he kept rates artificially low - the bankers wanted that too right? Greenspan also turned a blind eye to the pending blow up of the derivatives market, and testified before Congress that there was no risk - which is what Goldman, Lehman and AIG wanted right? So, the banks got everything they wanted. The environment was ripe for abuse, and guess what? There was rampant abuse, and no one has gone to jail for their CRIMES, not MISTAKES. Oh, but the private market will simply fix their "mistakes"? Sure, but not until they lay waste to land with bodies lying all around Oh by the way, the same gov't that you criticize, gave these same bankers massive bailouts of taxpayer money. With all due respect, to politicize the issue as "Democrats demonizing Wall Street" is the equivalent of journalistic malpractice. So, if I leave my car unlocked, and it gets stolen, then it's my fault right? The thief didn't have to steal it. Policy was shaped to give Wall Street an advantage, they took it and then some. If you're going to get political then be fair about it. Why don't Republicans admit that the "free market" left unchecked has it downside? No, they continue to turn a blind eye as if the banks and Wall Street has no responsibility.

So some people got some loans they couldn't afford (as if the only folks taking substantial risks were the one's who couldn't afford a home), and those individuals are paying a price right now. What price are the banks paying now that they're flush with cash? I know plenty of high income earners who thought, b/c they made a little bit of money on one transaction, thought they could just start "flipping" houses.

When Wall Street packages these same loans, "buys" a AAA rating from a rating agency, and sell them to unsuspecting investors and institutions, slice them up again, and keep selling them, that's where the real "pricing mechanism" gets thrown out of whack b/c access is too easy. AIG then insures these massive amounts of loans that it can't even cover? Why? Because they wanted that premium. It was millions and millions of dollars to the bottom line. To argue, that b/c the gov't owns the monetary system is that reason we are here now just doesn't hold water. We've known that for decades.

I'm supposed to believe that Allison and BB&T sat in a conference room and said let's not reduce risk b/c the gov't can step in at anytime and prop up the housing market? That doesn't even make sense to me. I'll have to read the book now. What makes more sense to me is, "Look, this housing market is getting frothy, we know this party has to end at some point; however, we don't want to lose market share to our competition, so let's keep it going. If we screw this up, then all the banks have screwed up, and the gov't is going to have to back us up anyway if they don't want this house of cards to come tumbling down".

on Jan 11, 2013

Am sorry I have let my response go a month. Deregulation? A myth. The regulatory burden really jumped in the Dubbya years. Hmm. According to the Cato Institute, regulatory costs peaked in 2005-2007, that would be the peak of the bubble. Gub'ment (use a Michigan Militia accent) spent $2.07bn (in adjusted dollars) in 2007 compared to $725million in 1980. Again, the numbers reflect inflation. Oh, and what about the Privacy Act, Sarbanes-Oxley and the Patriot Act, all leveled on financial services during Dubbya's time? Deregulation? I think you meant, "misregulation."

on Dec 7, 2012

I am amazed that a banker could justify writing questionable business because the government didn't discourage him from doing so - and blame the result on government manipulation of the market and not on lack of effective oversight/regulation.

I am amazed that the government can be blamed for the greed
and duplicity of the DEREGULATED market; the special entities used to hold dubious investments; the end of month
transactions to paper over liabilities; the packaging of
dubious, if not doomed, mortgages that were rated and sold as investment grade to unsuspecting buyers.

I am less amazed that the role of derivatives in creating the crisis is not commented on more often. Derivatives are essentially bets, and there are no limit to how many bets can be placed on a transaction. AIG alone had how much in derivative exposure - $100+ Trillion? No wonder banks wouldn't lend to each other and credit dried up. Who knew how much risk the counterparty had on its books. As one commentator said: if you had ten bottles of water and only one was poisoned, only one - which would you drink from?

The late Leona Helmsley famously said that "only the little people pay taxes." Well, only the "little people" are held to a fiduciary standard of conduct.

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