Deeper causes of_the_financial_crisis

The Deeper Causes of the Financial Crisis –

Mortgages Alone Cannot Explain It

by Mark Adelson1

27 September 2012 (working paper)

ABSTRACT

The losses on U.S. residential mortgage loans are too small to explain the magnitude of the 2008

financial crisis. The total losses, including the losses realized to date and those yet to be realized,

should fall in the range of $750 billion to $2 trillion. The full, global magnitude of the crisis is

significantly larger – probably in the range of $5 trillion to $15 trillion – depending on the

approach for measuring it. This implies that losses on residential mortgage loans cannot have

been the main cause of the crisis: they can only have been a trigger that served to unleash the

true causes. The failure or near failure of a significant number of major financial firms suggests

that high leverage and strong risk appetites were important immediate causes of the crisis.

However, explaining the sources of high leverage and strong risk appetites requires probing for

deeper causes that developed over a longer period. This article proposes the following deeper

causes: securities firms converting from partnerships to corporations, the 30-year trend of

deregulation, the quant movement, the spread of risk-taking culture through the financial

industry, and globalization.

Keywords: financial crisis, mortgage loans, leverage, risk appetite, financial institutions,

deregulation

JEL Classifications: G01, G18, G21, G24, G32, K22, N22

1 Mark Adelson is an independent consultant on credit analysis, risk management, securitization, fixed income

strategy, and related litigation matters. Margaret Culhane, Thomas Hughes, and David Jacob provided comments,

guidance, and insights without which this paper would not have been possible. Any mistakes or inaccuracies in the

paper are solely the author's responsibility.

The Deeper Causes of the Financial Crisis Mark Adelson

www.markadelson.com – 2 – Working Paper 9/27/2012

I. Introduction

1. The all-in cost of the 2008 global financial crisis is huge. It must be reckoned in terms of

trillions of dollars. The numbers are so big that they seem more natural in a discussion of

physics or astronomy than in finance. Depending on how one measures it, the cost of the crisis

appears to fall in the range of $5 trillion to $15 trillion. For example, one measure of the cost is

the decline in the aggregate value of the world's stock markets. After an initial drop of more than

$35 trillion, the world's stock markets have leveled-off at $10 trillion to $12 trillion below the

pre-crisis peak.

2. By comparison, the losses on U.S. residential mortgage loans at the onset of the crisis –

including both losses that have already been realized and those yet to come – appear modest.

This paper estimates that all-in losses should fall in the range of $750 billion to $2 trillion. To be

sure, those are big numbers. However, they are not nearly big enough to explain the impact of

the financial crisis. Thus, although losses on residential mortgage loans may have served as a

spark that ignited a powder keg of true underlying causes, the mortgage losses themselves are not

one of the true causes.

3. If mortgage losses cannot explain the financial crisis, what can? The immediate causes seem to

be behaviors of financial firms, particularly high leverage and strong risk appetite. It is not a

great leap to indentify those factors because a significant number of major financial firms failed

or nearly failed in the early years of the crisis. However, identifying the immediate causes is

only partly satisfying. It begs the question of what were their underlying drivers; what were the

deeper causes? This article suggests five deeper causes.

4. In contrast to other articles that emphasize the immediate causes of the financial crisis, this one

explores deeper causes that all have roots stretching back decades. In other words, the

foundations of the 2008 financial crisis were not laid in the early- or mid-2000s, but rather in the

1970s, 1980s, and 1990s.

5. This article is organized into six parts. The first is this introduction. The second part attempts to

measure the magnitude of the financial crisis a few different ways. The third part addresses the

amount of losses from defaults on U.S. residential mortgage loans. The fourth considers the

immediate causes of the crisis and the fifth suggests five deeper causes. The sixth part

concludes.

II. The Cost of the Financial Crisis

6. Reckoning the real cost of the financial crisis is a difficult matter. However, by any reasonable

approach, it amounts to many trillions of dollars. The following discussion considers several

approaches for quantifying the cost. Most of the approaches are incomplete. That is, they

capture only a single dimension of the cost of the financial crisis or they cover only a limited

geographic region. None actually covers the full cost on a global basis.

7. Market Capitalization: One way is to look at the market capitalization of the world's equity

exchanges. From that perspective, the financial crisis brought about a temporary decline of



roughly $37 trillion in the aggregate market capitalization of the world's equity markets. After a

partial recovery, the persisting erosion of equity values remains in the ballpark of $10 trillion to

$12 trillion.

8. As shown in Chart 1 below, the market capitalization of the world's equity markets peaked at

roughly $62.5 trillion in the fourth quarter of 2007 and declined to a low of roughly $25.5 trillion

in the first quarter of 2009. The decline represented an erosion of roughly $37 trillion of equity

value. Subsequently, the market capitalization recovered some of the lost ground, reaching $50

trillion in 2010Q4. Since then, it has fluctuated in the range of roughly $45 trillion to $55

trillion. Thus, the longer-term effect of on the world equity markets can be viewed as an erosion

of roughly $10 trillion to $12 trillion of equity value.

Chart 1: Bloomberg World Exchange Market Capitalization

20

30

40

50

60

2004 2005 2006 2007 2008 2009 2010 2011 2012

$ trilli

ons

Source: Bloomberg (WCAUWRLD <Index>).

9. World GDP: A second way to consider the cost of the financial crisis is in terms of the impact

on world GDP. World GDP contracted by roughly $3 trillion in 2009 relative to 2008. That

amounted to a 5.25% decline, the largest decline, by far, since 1960. In the 48 year period from

1960 to 2008, world GDP had declined in only four years (1982, 1997, 1998, and 2001), and the

largest percentage decline in any of those years was 0.96% in 1982. Against that background,

the 5.25% decline of 2009 is quite remarkable.



10. Chart 2 below shows the data as compiled by the World Bank. World GDP reached

approximately $61.3 trillion in 2008, before declining to $58.1 trillion in 2009. Growth returned

in 2010, with world GDP advancing to $63.3 trillion.

Chart 2: World GDP

-20

0

20

40

60

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

$ trilli

ons

-20%

0%

20%

40%

60%

80%

100%

120%

140%

YoY

Change

YoY Change (RHS)

Contractions

World GDP (LHS)

Source: World Bank (http://data.worldbank.org/indicator/NY.GDP.MKTP.CD).

11. U.S. Household Wealth: A third way to consider the cost of the financial crisis is in terms of the

loss of U.S. household wealth. This approach naturally excludes overseas effects, but it is

nonetheless illustrative. U.S. household net worth experienced a temporary decline of more than

$16 trillion and a persisting decline of more than $4 trillion.

http://data.worldbank.org/indicator/NY.GDP.MKTP.CD



12. As shown on Chart 3 below, U.S. household net worth peaked in 2007 at roughly $67.5 trillion.

It subsequently declined by more than $16 trillion over 2008 and part of 2009 to a level of about

$51.3 trillion. According to the Federal Reserve, a key driver was the loss of $7 trillion of home

equity as a result of the bursting of the housing bubble. Household net worth has since recovered

to nearly $63 trillion, but that is still more than $4 trillion below its 2007 peak.2 Also, a good

portion of the recent rise in household net worth shown on the chart comes from stock market

gains since 2011Q4.

Chart 3: U.S. Household Net Worth

40

45

50

55

60

65

70

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

$ trilli

ons

Source: Bloomberg (NWORVALU <Index>), Federal Reserve z.1 reports, table B.100.

13. Even more striking, however, is how the decline in household net worth from 2007 to 2010 was

distributed among American families. According to the latest Federal Reserve Survey of

Consumer Finances, the median net worth of American families declined from $126,400 in 2007

to $77,300 in 2010, a decline of nearly 39%. That decline pushed the median net worth down to

roughly the level of 1992, wiping out nearly two decades of growth.3 Significantly, the

wealthiest and highest-income households were largely insulated from the decline. In other

words, it fell primarily on the middle-class and working-class households. Thus, the hardship of

the net worth erosion landed primarily on the shoulders least able to bear the burden. Those

households have experienced only a small share of the offsetting stock market growth since mid-

2010.

2 Board of Governors of the Federal Reserve System, The U.S. Housing Market: Current Conditions and Policy

Considerations, white paper (4 Jan 2012) http://www.federalreserve.gov/publications/other-reports/files/housing-

white-paper-20120104.pdf; see also Krueger, A., Statement for the Treasury Borrowing Advisory Committee of the

Securities Industry and Financial Markets Association (3 May 2012) http://www.treasury.gov/press-center/press-

releases/Pages/tg683.aspx (Alan Krueger is the Assistant Secretary for Economic Policy and the Chief Economist of

the U.S. Dept. of the Treasury).

3 Briker, J., Kennickell, A., Moore, K., & Sabelhaus, Changes in U.S. Family Finances from 2007 to 2010: Evidence

from the Survey of Consumer Finances, Federal Reserve Bulletin, vol. 98, no. 2, at pp. 17-21 (June 2012)

http://www.federalreserve.gov/pubs/bulletin/2012/pdf/scf12.pdf.

http://www.federalreserve.gov/publications/other-reports/files/housing-white-paper-20120104.pdf


http://www.treasury.gov/press-center/press-releases/Pages/tg683.aspx


http://www.federalreserve.gov/pubs/bulletin/2012/pdf/scf12.pdf



14. Financial Sector Writedowns: A fourth way to gauge the impact of the crisis is by focusing on

the financial sector. Just within the financial sector, the IMF estimated in 2009 that the banks

and other financial firms would face $4.1 trillion of write-downs associated with the financial

crisis.4 Bloomberg reports that aggregate write-downs by financial firms around the world had

reached slightly more than $2 trillion by the end of 2011Q3, and that firms had received nearly

$1.6 trillion of capital infusions.5

15. Central Bank Balance Sheets: A fifth way to view the cost of the financial crisis is in terms of

the expansion of central bank balance sheets in the period following the onset of the crisis.

Expansion of central bank balance sheets reflects one dimension of governmental response to the

crisis. It is revealing because the magnitude of governmental response should give some

reflection of the size of the problem being addressed.

16. As shown on Chart 4, the balance sheets of the U.S. Federal Reserve, the European Central

Bank, and the Bank of England each expanded markedly in the period following the onset of the

crisis.

Chart 4: Change in Central Bank Assets following the Onset of the Financial

Crisis

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

Jul-

2006

Jan-

2007

Jul-

2007

Jan-

2008

Jul-

2008

Jan-

2009

Jul-

2009

Jan-

2010

Jul-

2010

Jan-

2011

Jul-

2011

Jan-

2012

Jul-

2012

Asse

ts (

US

$ t

rilli

on

s)

Bank of England

European Central Bank

U.S. Federal Reserve

Source: Bloomberg (FARBAST, EBBSTOTA, EURUSD, B111B75A, GBPUSD).

4 International Monetary Fund, Global Financial Stability Report – April 2009, pp. 30, 67-71,

http://www.imf.org/external/pubs/ft/gfsr/2009/01/pdf/text.pdf.

5 Bloomberg WDCI <go>.

http://www.imf.org/external/pubs/ft/gfsr/2009/01/pdf/text.pdf



17. At the onset of the crisis, the combined assets of the Fed, the ECB, and the BOE stood at slightly

more than $3 trillion. Shortly after the start of the crisis, the combined assets grew by roughly

$2.5 trillion, to an interim peak level of roughly $5.5 trillion. After contracting strongly for a

brief period in early 2009, the level of the combined assets hovered in the range of $5 trillion to

$5.5 trillion through the remainder of 2009 and 2010. The start of 2011 marks the beginning of a

second phase of balance sheet expansion, which brought the combined assets to nearly $7.5

trillion by the start of 2012. Thus, the overall growth amounts to more than $4 trillion.

18. Magnitude of U.S. Government Response: A sixth way to view the cost of the financial crisis

is in terms of the measures deployed in the U.S. for responding to the crisis. Naturally,

measuring the U.S. government response somewhat ignores the international dimension and it

naturally omits costs born directly by households and business in the form of reduced income

and wealth. Nonetheless, the numbers are revealing.

19. As shown in Table 1 below, CNNMoney reports that, as of 2009, the federal government had

deployed a net amount of roughly $3 trillion of response measures as follows:6

Table 1: U.S. Government Bailout Measures

($ billions)

Item Committed

Amount Net Invested

Amount

Troubled Asset Relief Program 700 356.2

Federal Reserve Rescue Efforts 6,400 1,500

Federal Stimulus Programs 1,200 577.8

American International Group 182 127.4

FDIC Bank Takeovers 0 45.4

Other Financial Initiatives 1,700 366.4

Other Housing Initiatives 745 130.6

Totals 10,927 3,103.8

Source: CNNMoney.com (see footnote 6)

20. Of course, the raw numbers can lend themselves to various interpretations. For example, earlier

this year the U.S. Treasury released a report asserting that "[o]verall, the government is now

expected to at least break even on its financial stability programs and may realize a positive

return."7 Some questioned the Treasury's math.

8

21. Focusing more narrowly on just the Fed's crisis response measures offers additional insight.

Researcher James Felkerson of the University of Missouri-Kansas City offers an interesting take

6 Goldman, D., CNNMoney.com's Bailout Tracker (16 Nov 2009)

http://money.cnn.com/news/storysupplement/economy/bailouttracker/index.html; see also Kuntz, P. & Ivry, B., Fed

Once-Secret Loan Crisis Data Compiled by Bloomberg Released to Public, Bloomberg News (23 Dec 2011)

http://www.bloomberg.com/news/2011-12-23/fed-s-once-secret-data-compiled-by-bloomberg-released-to-

public.html.

7 Treasury Department, The Financial Crisis Response in Charts, p. 10 (Apr 2012)

http://www.treasury.gov/resource-center/data-chart-center/Documents/20120413_FinancialCrisisResponse.pdf.

8 Weill, J., Dream of Taxpayer Bailout Profit Is Just That, Bloomberg News (19 Apr 2012)

http://www.bloomberg.com/news/2012-04-19/hope-for-treasury-bailout-profits-rests-on-fuzzy-math.html.

http://money.cnn.com/news/storysupplement/economy/bailouttracker/index.html

http://www.bloomberg.com/news/2011-12-23/fed-s-once-secret-data-compiled-by-bloomberg-released-to-public.html


http://www.treasury.gov/resource-center/data-chart-center/Documents/20120413_FinancialCrisisResponse.pdf

http://www.bloomberg.com/news/2012-04-19/hope-for-treasury-bailout-profits-rests-on-fuzzy-math.html



on measuring the Fed's crisis response in a recent paper.9 Felkerson reports three types of

measures for the Fed's use of unconventional lender-of-last-resort facilities. The first measure is

the peak outstanding amount. The second is the peak transaction flow. The third is the

cumulative transaction flow. Table 2 summarizes Felkerson's findings:

Table 2: Federal Reserve Crisis Response by Unconventional Lender-of-Last Resort Facility

($ billions)

Program or Facility Peak

Outstanding

Outstanding as of Nov

2011

Peak Monthly

Flow

Peak Weekly Flow

Cumulative Flow

Term Auction Facility 493.0 0 347 3,818.4

Central Bank Liquidity Swap Lines 583.1 107.8 2,887 851.3 10,057.4

Single-tranche Open Market Operations 80.0 0 100 855.0

Term Securities Lending Facility and TSLF Options Program

235.5 0 110.8 2,005.7

Bear Stearns Bridge Loan 12.9 0 12.9

Maiden Lane I 28.8 3.27 28.8

Primary Dealer Credit Facility 146.6 0 728.6 8,951.0

AIG Revolving Credit Facility 85.0 0 140.3

AIG Securities Borrowing Facility 0 802.3

Maiden Lane II (AIG) 19.5 2.87 19.5

Maiden Lane III (AIG) 24.3 8.61 24.3

Preferred Interests in AIA/ALICO (AIG) 25.0 0 25.0

Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility

152.1 0 88.6 217.5

Commercial Paper Funding Facility 348.2 0 144.6 737.1

Term Asset-Backed Securities Loan Facility 48.2 7.57 10.7 71.1

GSE Direct Obligation Purchase Program 160.0 100.8 160.0

Agency MBS Purchase Program 1,128.7 849.3 80.5 1,250.0

Aggregate Results 1,716.6 1,864.1 29,785.4

Source: Felkerson (2012) (see footnote 9).

22. As shown in Table 2, Felkerson reports that the cumulative flow of all of the Fed's

unconventional lender-of-last-resort facilities amounted to nearly $30 trillion. The number

counts a $1 loan renewed each day for ten days as $10. Thus, the $30 trillion transaction flow

cannot be viewed as a direct measure of the cost of the financial crisis. However, Felkerson

argues that "each unconventional transaction by the Fed represents an instance in which private

markets were incapable or unwilling to conduct normal intermediation and liquidity provisioning

activities" and, therefore, that the "magnitude of the Fed's unconventional rescue efforts" is

captured most meaningfully by the aggregate cumulative flow.10

23. Reduced Economic Output: In January, the Congressional Budget Office estimated that the

recession associated with the financial crisis would cause a $5.7 trillion shortfall in total U.S.

9 Felkerson, J., A Detailed Look at the Fed's Crisis Response by Funding Facility and Recipient, Levy Economics

Institute of Bard College, Public Policy Brief No. 123 (Apr 2012)

http://www.levyinstitute.org/publications/?docid=1517.

10 Id. at pp. 6-7.

http://www.levyinstitute.org/publications/?docid=1517



output from 2008 through 2017. Of that shortfall, $2.6 trillion had already occurred through

2011Q3, and the remaining $3.1 trillion was project to occur from 2011Q4 through 2017.11

24. More recently, Better Markets, a somewhat left-leaning think tank, published a study that

estimates the cost of the financial crisis to be at least $12.8 trillion in terms of reduced U.S.

economic output from 2008 through 2018.12

It arrives at that figure by combining two elements:

(i) an estimated $7.6 trillion of lost economic output from 2008 through 2018 and (ii) an

estimated $5.2 trillion of avoided loss that has been prevented by government policy actions.

The second element seems questionable because it relates to hypothetical loss that has been

avoided. On the other hand, the rational for including it is that it is an estimate of loss that would

have occurred in the absence of remedial policies, which were hardly without cost.

25. Better Markets further argues that its $12.8 trillion figure is a conservative estimate, because

many costs are not readily quantifiable but are nonetheless highly significant:

Not only does [the $12.8 trillion figure] omit the incalculable cost of preventing the collapse of the

financial system and avoiding a second Great Depression; all the measures necessary to avoid that

outcome; and the human suffering that accompanies unemployment, foreclosure, homelessness,

and related damage, it also fails to account for the destruction of human capital on a widespread

basis. There are millions of Americans and perhaps tens of millions of Americans who will never

regain their earnings, educations, skills, and trainings [sic] that they lost during and as a result of

the crises. This is, obviously, terrible for those individuals, but it also damages the entire country

as our potential GDP is far lower than it otherwise would be if this human capital had not been

destroyed. And, it is not simply a matter of lost long-term productivity. Lower growth means,

among other things, less innovation and, therefore, less technological progress. The consequences

of such losses to a society are indeterminable, but potentially very far-reaching and long-lasting.13

11

Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2012 to 2022, pp. 26-28

(Jan 2012) http://www.cbo.gov/sites/default/files/cbofiles/attachments/01-31-2012_Outlook.pdf.

12 Kelleher, D., Hall, S., & Bradley, K., The Cost of the Wall Street-Caused Financial Collapse and Ongoing

Economic Crisis is More Than $12.8 Trillion, Better Markets, pp. 13-15 (Sep 2012)

http://www.bettermarkets.com/sites/default/files/Cost%20Of%20The%20Crisis_0.pdf.

13 Id. pp. 14-15.

http://www.cbo.gov/sites/default/files/cbofiles/attachments/01-31-2012_Outlook.pdf

http://www.bettermarkets.com/sites/default/files/Cost%20Of%20The%20Crisis_0.pdf



26. So, summing up so far, different ways of measuring the cost of the financial crisis point to

different numbers, but all of them indicate all-in costs substantially larger than $2 trillion. Table

3 summarizes the preceding material:

Table 3: Measuring the Impact of the 2008 Global Financial Crisis

Item Amount

($ trillions)

Large Scale Measures

Decline in total value of world stock markets (Chart 1) 10-12

One-year decline in world GDP (2009) (Chart 2) 3

Decline in U.S. household wealth (Chart 3) 4

Reduced U.S. economic output 2008-2018 5.7-12.8

Measures Focused on the Financial Sector Only

Financial sector writedowns (global, including future writedowns) 2-4

Growth of Fed, ECB, and BOE balance sheets (to date) 4

Peak outstanding U.S. government support (to date) 1.7

Peak weekly flow of U.S. government support (to date) 1.9

Cumulative flow of U.S. government support (to date) 28.8

27. None of the figures in Table 3 actually captures the full cost of the crisis globally and across all

sectors. Several of the figures measure effects only in the U.S. and others focus just on the

financial sector. However, the decline in the value of world stock markets and the reduction in

U.S. economic output appear to give the best signals of the global impact. They suggest a range

of $5 trillion to $15 trillion as the total cost.

III. Sizing the Losses from Mortgage Loan Defaults

28. Losses from U.S. residential mortgage loans that existed at the onset of the crisis likely will fall

in the range of $750 billion to $2 trillion. Moreover, they will probably end up being closer to

the lower end of the range than the upper end. That includes both losses realized to date and

those that will be realized in the future. Either way, the amount of losses is far too small to

explain the full magnitude of the financial crisis.

29. This article attempts to estimate the total losses with a top-down approach and then compares the

result to some of the estimates published by others.

A. Top-Down Approach

30. A top-down approach for sizing the losses from mortgage loan defaults entails three steps. The

first is estimating a range for the proportion of loans that is likely to go through foreclosure (or

similar liquidation resulting in a loss). The second step is estimating a range for the severity of

loss upon foreclosure. The final step is applying the ranges for foreclosure frequency and

severity to produce a range of losses.



31. Frequency of Default: As of the fall of 2007, there were about 48.7 million owner-occupied

homes in the U.S with some kind of mortgage.14

The total amount of mortgage debt on those

homes was around $11 trillion.15

From early 2007 through early 2012, about four million homes

were lost through foreclosures.16

Recently, the rates of delinquencies and foreclosures have

declined,17

but, as of early 2012, roughly 11 million mortgage loans had negative equity and

another 2.5 million had less than 5% positive equity.18

This suggests that many additional

foreclosures will have to happen before the housing sector can fully recover from the effects of

the real estate bubble.

32. In this writer's view, many of the underwater loans will default and end up in foreclosure, but

also many will survive and perform. Many borrowers with underwater loans are able to afford

their monthly payments, and many have non-financial incentives to stay in their homes, such as

proximity to their jobs or preference for their local school system. Additionally, determining the

underwater status of loans is an inherently imprecise exercise. It does not consistently capture

differences in the quality of maintenance and the effect of modest improvements.

33. Therefore, subject to a fair amount of uncertainty, a fair estimate is that between one-third and

two-thirds of today's at-risk loans will end up going through foreclosure. That translates into

roughly an additional four million to eight million loans. Together with the four millions loans

that already went through foreclosure, that produces a grand total in the range of roughly eight

million to twelve million loans. Thus, relative to the original 48.7 million owner-occupied

homes with mortgage financing in 2007, the proportion that ultimately will suffer foreclosure

(including those that already have) will likely be in the range of roughly 15% to 25%.

34. Severity of Loss on Foreclosure: Estimating the severity of loss on defaulted mortgage loans

also presents material uncertainty. So far, loss severities on defaulted loans have displayed wide

variation. For subprime loans, which account for most of the defaults to date, average monthly

severities have been very high, exceeding 70% in some months. By contrast, losses on alt-A

mortgages have been running in the range of 50% to 60%, while loss severities on prime-quality

loans have been the lowest, usually running around 40% or less.

14

U.S. Census Bureau, Statistical Abstract of the United States, 2010 Edition, table 963

http://www.census.gov/prod/2009pubs/10statab/construct.pdf.

15 Board of Governors of the Federal Reserve System, Flow of Funds Accounts of the United States, Flows and

Outstandings First Quarter 2008, Federal Reserve Statistical Release Z.1, p. 59, table L.2, line 11 (5 Jun 2008)

http://www.federalreserve.gov/releases/z1/20080605/z1.pdf.

16 Foreclosures (2012 Robosigning and Mortgage Servicing Settlement), New York Times, Times Topics (updated 2

Apr 2012) http://topics.nytimes.com/top/reference/timestopics/subjects/f/foreclosures/index.html. From the start of

the financial crisis in the fall of 2008, through the first two months of 2012, there were roughly 3.3 million

completed foreclosures. CoreLogic, CoreLogic Reports More Than 860,000 Completed Foreclosures Nationally in

the Last Twelve Months, press release, (25 Mar 2012) http://www.corelogic.com/about-us/news/corelogic-reports-

more-than-860,000-completed-foreclosures-nationally-in-the-last-twelve-months.aspx.

17 Mortgage Bankers Association, Delinquencies Decline in Latest MBS Mortgage Delinquency Survey, press

release (16 May 2012) http://www.mbaa.org/NewsandMedia/PressCenter/80807.htm.

18 Corelogic, Corelogic Reports Negative Equity Increase in Q4 2011, press release (1 Mar 2012)

http://www.corelogic.com/about-us/researchtrends/asset_upload_file360_14435.pdf.

http://www.census.gov/prod/2009pubs/10statab/construct.pdf

http://www.federalreserve.gov/releases/z1/20080605/z1.pdf

http://topics.nytimes.com/top/reference/timestopics/subjects/f/foreclosures/index.html

http://www.corelogic.com/about-us/news/corelogic-reports-more-than-860,000-completed-foreclosures-nationally-in-the-last-twelve-months.aspx


http://www.mbaa.org/NewsandMedia/PressCenter/80807.htm

http://www.corelogic.com/about-us/researchtrends/asset_upload_file360_14435.pdf



35. Loss severities should decline with the passage of time because of a burn-out effect. All other

things being equal, the most distressed loans, including loans that will produce the largest losses,

should default earlier in the life of a vintage. A substantial portion of the most distressed loans

from the 2005, 2006, and 2007 vintages have already defaulted and gone through foreclosure or

are in the process. This suggests a plausible range for all-in severities is 45% to 65%.

36. Combining the frequency and severity ranges above produces a rough, top-down estimate for a

range of losses attributable to mortgage loan defaults as follows:

high end: $11 trillion in loans × 25% frequency × 65% severity ≈ $1.8 trillion

low end: $11 trillion in loans × 15% frequency × 45% severity ≈ $750 billion

B. Third-Party Views

37. Somewhat surprisingly, there are few published estimates of the total amount of ultimate losses

from mortgage defaults following the bursting of the housing bubble. Around mid-2008, in the

early days of the crisis, PIMCO offered such an estimate: $1 trillion.19

Several months later,

there were headlines indicating that the IMF had projected $1.4 trillion. However, careful

examination of the report indicates that the figure covered much more than mortgage defaults.

The report's actual figure for mortgage losses was just $170 billion.20

38. In March 2012, noted mortgage researcher Laurie Goodman testified to a Senate subcommittee

that between 7.4 million and 9.3 million U.S. residential mortgage loans have "yet to face

foreclosure and eventual liquidation."21

Combining Goodman's estimate of future foreclosures

with the severity range described above (45% to 65%) and the four million loans that have

already been through foreclosure implies that the grand total for losses should be in the range of

roughly $1.2 trillion to $2 trillion.

39. In December 2009, Barclays estimated a that total losses on loans held in the portfolios of Fannie

Mae and Freddie Mac or included in MBS issued by them would total around $275 billion.22

For

the period 2005 through 2007, originations of conforming mortgage loans (i.e., those eligible for

purchase and securitization by Fannie Mae and Freddie Mae) constituted just 38% of total

originations.23

If the population of conforming loans from that period was representative of the

19

Gross, W., Mooooooo!, PIMCO Investment Outlook (Aug 2008)

http://media.pimco.com/Documents/IOAug_08_Web_Final.pdf.

20 International Monetary Fund, Global Financial Stability Report – October 2008, p. 67, table 1.9 (2008)


21 Goodman, L., 3/15/2012 Testimony of Laurie S. Goodman, Amherst Securities Group To the U.S. Senate

Subcommittee on Housing, Transportation and Community Development Topic— Strengthening the Housing Market

and Minimizing Losses to Taxpayers, (15 Mar 2012)

http://banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=0f96e0ff-8500-41a5-a0f2-

0139d0df2e07.

22 Setia, R., Ma, J., Strand, N., Velayudham, S., & Chen, D., GSEs: Back to the Future, Barclays Capital Interest

Rates Research, p. 5 (11 Dec 2009).

23 Inside Mortgage Finance Publications, 2011 Mortgage Market Statistical Annual, vol. 2, p.3 (2011).

http://media.pimco.com/Documents/IOAug_08_Web_Final.pdf


http://banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=0f96e0ff-8500-41a5-a0f2-0139d0df2e07




entire population of loans from 2005-2007, and assuming that only a negligible amount of losses

would come from earlier origination vintages, that would imply an aggregate total loss amount of

roughly $725 billion. However, non-conforming subprime and alt-A mortgage loans represented

about 29% of originations from 2005 to 2007. If losses on subprime and alt-A loans run at twice

the rate as losses on conforming loans, that would imply an aggregate total loss amount of

roughly $930 billion.

40. In May 2012, the Federal Housing Finance Agency reported that Fannie Mae and Freddie Mac

had incurred losses (including provision for future losses) of $218 billion on their single family

mortgage loans from 2008 through the third quarter of 2011.24

If the provision for future losses

is sufficient to capture all or nearly all of future losses, then, compared to the Barclay's estimate

of $275 billion, the FHFA's reported number of $218 would imply a 21% improvement. Using

the same approach as in the previous paragraph would imply an aggregate total loss amount of

roughly $600 billion by simple extrapolation or an amount of roughly $740 billion allowing for

double the loss rates on subprime and alt-A loans.

41. Overall Range for Mortgage Losses: So, for third-party views, the reasonable low end of the

range would be the $740 billion suggested by extrapolation from the May FHFA report (¶40).

The reasonable high end of the range is the $2 trillion suggested by Goodman's forecast of the

number of defaults (¶38). That subsumes the range from the top-down approach. So, combining

the two and rounding away the small difference at the low end produces an overall range for

aggregate losses of $750 billion to $2 trillion. Table 4 summarizes the results:

Table 4: Summary of Estimates for Aggregate Losses on U.S. Residential Mortgage Loans that Existed at the Inception of the Financial Crisis

Low End High End

Top-down Approach $750 billion $1.8 trillion

Third Party Views $740 billion $2 trillion

Combined $750 billion $2 trillion

42. Because housing market conditions now seem to be generally improving, it appears more likely

that the final result will be closer to the low end of the range than the high end. Either way,

however, the total amount of losses from defaulted mortgage loans seems too small to account

for the magnitude of the financial crisis, regardless of how one measures it.

43. Although mortgage losses should end up in the range of "only" $750 billion to $2 trillion

(sarcasm intended), there is an additional element that gives them even greater psychological

impact. The mortgage losses produced a crisis on confidence in assets and financial products

that had been viewed as virtually riskless, from a credit perspective. For example, before the

crisis, most market participants had viewed the senior classes of non-agency MBS (i.e., private-

label mortgage-backed securities) as carrying infinitesimal credit risk. That expectation was

later undermined by defaults of thousands of such securities. In a related vein, the bursting of

the housing bubble undermined homeowners' confidence in their homes as investments. Thus,

24

Federal Housing Finance Agency, Office of Inspector General, Fannie Mae and Freddie Mac: Where the

Taxpayer's Money Went, White Paper WPR-2012-02, p. 20 (24 May 2012)

http://www.fhfaoig.gov/Content/Files/FannieMaeandFreddieMac-WheretheTaxpayersMoneyWent.pdf.

http://www.fhfaoig.gov/Content/Files/FannieMaeandFreddieMac-WheretheTaxpayersMoneyWent.pdf



even though mortgage losses are insufficient to explain the full magnitude of the financial crisis,

they did have significant and ongoing effects on both Wall Street and Main Street.

IV. The Immediate Causes of the Financial Crisis (Causa Proxima)

44. Which brings us to the question: What did cause the financial crisis? This writer shares the view

expressed by various commentators that high leverage and strong risk appetite at financial firms

are two of the immediate causes of the crisis.

45. The central character of high leverage and strong risk appetite at financial firms is evident from

the fact that a number of major firms failed and many others would have failed if the government

had not saved them. As shown on Table 5, many of the largest firms experienced a drastic

reduction in their market capitalization (as reflected in a sharp drop of their stock prices)

between the start of 2007 and the end of 2008. While market capitalization is not, in itself, a

direct indicator of creditworthiness, sustained erosion of market capitalization can reflect an

underlying deterioration of creditworthiness. 25

Table 5: Change in Stock Prices of Selected Financial Business 1/1/2007 to 12/31/2008

Company Credit Rating

at 1/1/2007 (S&P) Change in Stock

Price 2007-08 Notes

AIG AA+ -97.7% ~$183b in bailout, U.S. govt owns 80% stake

Bear Stearns AA- -94.2% Shotgun marriage with JP Morgan for $10/share

Citigroup AA -86.7% Hybrids exchanged, U.S. gov’t took 36% equity

IndyMac BBB -99.6% Seized by FDIC in 2008, auctioned off in March 2009

Lehman AA- -100.0% Bankruptcy 9/15/2008.

Merrill Lynch AA- -18.1% Bought out by B-of-A 9/14/2008

Northern Rock A+ -92.4% Nationalized 2/22/2008

RBS AA -92.6% Part nationalization, UK gov’t took 84% stake

UBS AA+ -76.3% Write-downs >$50B since 2007

Wachovia AA- -89.3% “Silent run" in Sep 2008; acquired by Wells Fargo

WaMu A -100.0% Receivership 9/25/2008

Fannie Mae AA- -98.6% Conservatorship 9/7/2008, U.S. Treasury holds preferred stock and warrants worth 80% stake Freddie Mac AA- -98.9%

Ambac AAA -98.5% Bankruptcy 11/8/2010

MBIA AAA -94.3% Rated B, attempting restructuring

FGIC AAA n.a. Bankruptcy 8/3/2010

FSA AAA n.a. Acquired by AGC in July 2009

ACA A n.a. Restructuring plan 8/8/2008

AGC AAA -56.4% Now rated AA-

CIFG AAA n.a. CC rating withdrawn 2/16/2010

25

The notion that erosion of equity reflects a decline in a company's creditworthiness is central to a class of

economic models known as "Merton models." Merton, R., The Pricing of Corporate Debt: The Risk Structure of

Interest Rates, Journal of Finance, vol. 29, no. 2, pp. 449–70 (May 1974)

http://www.sam.sdu.dk/undervis/92071.E01/Merton74.pdf.

http://www.sam.sdu.dk/undervis/92071.E01/Merton74.pdf



46. But, high leverage and strong risk appetite are unsatisfying explanations. They beg the question

of why financial firms embraced high leverage and strong risk appetite. Attempting to answer

that question requires looking for deeper causes.

V. The Deeper Causes (Causa Remota)

47. Many Interpretations: Many authors have written about the financial crisis and offered views

about the underlying causes. Both academics and journalists have weighed-in and offered their

interpretations of the facts. Prof. Andrew Lo of MIT has released a working paper that reviews

21 books on the subject.26

According to Lo, there is significant disagreement among the authors

of the books about both the underlying causes of the crisis and the basic facts. He compares the

situation to the story in the famous Japanese film Rashomon, where different witnesses give

conflicting accounts of a crime. According to Lo, the conflicting accounts of the financial crisis

are like the conflicting accounts of the crime in the movie.

48. FCIC Report: Prof. Lo mentions the official report of the Financial Crisis Inquiry Commission

(FCIC),27

but does not count it as one of the 21 books that he reviews. He describes the report as

presenting "three different conclusions," referring to the majority view and two dissenting views.

He asserts that the FCIC report is a further example of conflicting accounts of what happened.

However, apart from some disagreement among the commissioners about interpretation, the

majority and the dissents appear to largely agree on the facts.

49. Indeed, the FCIC report, together with the associated records and data available online, is a

treasure trove of factual information about the crisis. This is not actually surprising; compared to

the journalists and academics who authored the 21 books reviewed by Prof. Lo, the FCIC had far

greater resources–including a staff of nearly 90 investigators, researchers, and writers–to find out

what happened and to record the story.

50. The FCIC report (the majority view) enumerates nine specific conclusions about the financial

crisis:28

i. the crisis was avoidable,

ii. widespread failures in financial regulation and supervision proved devastating to the

stability of the nation’s financial markets,

iii. dramatic failures of corporate governance and risk management at many systemically

important financial institutions were a key cause of this crisis,

iv. a combination of excessive borrowing, risky investments, and lack of transparency put

the financial system on a collision course with crisis,

26

Lo, A., Reading about the Financial Crisis: A 21-Book Review, working paper (9 Jan 2012)

http://www.argentumlux.org/documents/JEL_6.pdf.

27 Financial Crisis Inquiry Commission, Financial Crisis Inquiry Report, [hereinafter "FCIC Report"] (Jan 2011)

http://fcic.law.stanford.edu/report.

28 Id. pp. xv-xxv.

http://www.argentumlux.org/documents/JEL_6.pdf

http://fcic.law.stanford.edu/report



v. the government was ill prepared for the crisis, and its inconsistent response added to the

uncertainty and panic in the financial markets,

vi. there was a systemic breakdown in accountability and ethics,

vii. collapsing mortgage-lending standards and the mortgage securitization pipeline lit and

spread the flame of contagion and crisis,

viii. over-the-counter derivatives contributed significantly to the crisis, and

ix. the failures of credit rating agencies were essential cogs in the wheel of financial

destruction.

51. Of the FCIC's conclusions, several do not address the causes of the financial crisis. Others point

toward factors that may have enabled or exacerbated the crisis, but which are not fundamental

causes. Moreover, some of them overlap; for example, the second conclusion largely subsumes

the seventh. Nonetheless, in the majority of its conclusions, the FCIC was clearly pointing to its

view of underlying causes.

52. In contrast to the main FCIC report, the dissenting statement of three commissioners identifies

ten specific items as causes of the crisis:29

i. the credit bubble,

ii. the housing bubble,

iii. non-traditional mortgages,

iv. credit ratings and securitization,

v. financial institutions concentrated correlated risk,

vi. leverage and liquidity risk,

vii. risk of contagion,

viii. common shock,

ix. financial shock and panic, and,

x. financial crisis causes economic crisis.

53. The dissenting view differs from the majority by considering international comparisons to a far

greater degree. It emphasizes the formation of a credit bubble that extended far beyond the

sphere of housing and residential mortgages. Significantly, the dissent highlights that

derivatives, such as credit default swaps (CDS), cannot magnify losses because each derivative

contract is a zero-sum game; for every dollar of loss by one party to the contract there is a dollar

of gain for the other party. In addition, the dissent observes quite directly that declining home

prices and losses from defaulting mortgage loans are not sufficient to explain the crisis:

The story so far involves significant lost housing wealth and diminished values of securities

financing those homes. Yet even larger past wealth losses did not bring the global financial

system to its knees. The key differences in this case were leverage and risk concentration.30

29

Id. pp. 417-419.

30 Id., p. 427.



54. One of the FCIC commissioners, Peter J. Wallison, penned a separate dissenting statement of his

own. He attempts to explain the crisis largely as a consequence of national housing policy and

the development of "non-traditional" mortgage products (i.e., subprime and alt-A mortgage

loans). None of the other nine commissioners joined in that dissent. Non-traditional mortgage

products are merely a subset of the larger universe of residential mortgage loans. Thus, if the

losses on all residential mortgage loans are not sufficient to explain the magnitude of the

financial crisis, the impact of just a subset is also not a sufficient explanation.

55. Another Interpretation: This article adds another interpretation to the mix. In contrast to other

studies, this article attempts to differentiate immediate causes from deeper causes. Doing so

recognizes that there can be a chain of causation leading up to an event. Although every link in

the chain may bear investigation, the ones at the very start of the process generally are the most

important.

56. In this writer's view, there are at least five deeper causes that potentially can explain why many

financial firms had embraced high leverage and strong risk appetites in the years leading up to

the crisis:

i. securities firms converting from partnerships to corporations,

ii. deregulation over the past 30 years,

iii. the quant movement,

iv. the spread of risk-taking culture through the financial industry, and

v. globalization

57. Although each one might deserve an entire book, it receives just a brief discussion below:

58. Securities Firms Converting from Partnerships to Corporations: The first deeper cause is the

conversion of securities firms from partnerships to corporations. The change in organizational

form explains the change in incentives and risk-taking behavior at those firms. After the change,

non-owner employees became responsible for key risk decisions but had skewed incentives.

Instead of taking risks with their own money, the employees could take risks with shareholders'

money.

59. Securities dealers started converting from partnerships to corporations in the 1970s. The trend

continued through 1999, when Goldman Sachs, the last major securities firm in partnership form,

converted to corporate status. The conversion meant that managers were no longer necessarily

owners of the firm. The separation of management from ownership gave rise to the classic

"principal-agent problem," especially as the firms came to have employees with responsibility

for risk-taking who did not have substantial pre-existing equity stakes. The employees could

take risk with other peoples' (shareholders') money. If the outcomes were positive, the

employees could reap huge gains through incentive compensation schemes. If the outcomes

were negative, their downside was limited–they might get fired and have to get a new job, but

their accumulated personal wealth was generally not at risk. Michael Lewis embraces this point

in the epilogue of The Big Short, where he asserts that the former CEO of Salomon



had done violence to the Wall Street social order–and got himself dubbed the King of Wall Street–

when, in 1981, he'd turned Salomon Brothers from a private partnership into Wall Street's first

public corporation.31

60. Deregulation of Financial Services: The second deeper cause is deregulation of the financial

services industry. Deregulation enabled employees of financial firms to act on their incentives to

take new risks and greater risks.

61. Financial sector deregulation did not occur in isolation. It was part of a broader movement of

deregulation that started in the 1970s and affected many industries. Air travel, cable TV, electric

power, interstate trucking, natural gas transmission, railroads, and telephone service are all

examples of industries that experienced substantial deregulation over the past four decades.

Financial industry deregulation was just part of the larger trend. Key milestones in the roll-back

of financial regulation include the following U.S. laws:

the Depository Institutions Deregulation and Monetary Control Act of 1980,32

the Garn-St. Germain Depository Institutions Act of 1982,33

the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994,34

the Private Securities Litigation Reform Act of 1995,35

the Gramm-Leach-Bliley Act,36

and

the Commodity Futures Modernization Act of 2000.37

62. The FCIC report identifies the deregulation movement as one element of its "failures in financial

regulation" conclusion (see item ii in ¶ 50). The report states:

More than 30 years of deregulation and reliance on self-regulation by financial institutions,

championed by former Federal Reserve chairman Alan Greenspan and others, supported by

successive administrations and Congresses, and actively pushed by the powerful financial industry

at every turn, had stripped away key safeguards, which could have helped avoid catastrophe. This

approach had opened up gaps in oversight of critical areas with trillions of dollars at risk, such as

the shadow banking system and over-the-counter derivatives markets. In addition, the government

permitted financial firms to pick their preferred regulators in what became a race to the weakest

supervisor.38

31

Lewis, M. The Big Short – Inside the Doomsday Machine, New York. W.W. Norton (2010).

32 Pub. L. 96-221, 94 Stat. 132 (1980) http://www.fdic.gov/regulations/laws/rules/8000-2200.html.

33 Pub. L. 97-320, 96 Stat. 1469 (1982) http://www.fdic.gov/regulations/laws/rules/8000-4100.html.

34 Pub. L. 103-328, 108 Stat. 2338 (1994) http://www.gpo.gov/fdsys/pkg/BILLS-103hr3841enr/pdf/BILLS-

103hr3841enr.pdf.

35 Pub. L. 104-67, 109 Stat 737 (1995) http://www.gpo.gov/fdsys/pkg/PLAW-104publ67/pdf/PLAW-104publ67.pdf.

36 Pub. L. 106-102, 113 Stat. 1338 (1999) http://www.gpo.gov/fdsys/pkg/PLAW-106publ102/pdf/PLAW-

106publ102.pdf.

37 Pub. L. No. 106-554, 114 Stat. 2763A–365 (2000) http://www.gpo.gov/fdsys/pkg/PLAW-

106publ554/pdf/PLAW-106publ554.pdf.

38 FCIC Report, supra note 27, p. xviii.

http://www.fdic.gov/regulations/laws/rules/8000-2200.html

http://www.fdic.gov/regulations/laws/rules/8000-4100.html

http://www.gpo.gov/fdsys/pkg/BILLS-103hr3841enr/pdf/BILLS-103hr3841enr.pdf

http://www.gpo.gov/fdsys/pkg/BILLS-103hr3841enr/pdf/BILLS-103hr3841enr.pdf

http://www.gpo.gov/fdsys/pkg/PLAW-104publ67/pdf/PLAW-104publ67.pdf







63. Although certain steps along the path of financial deregulation were (in themselves) benign, the

cumulative effect of successive steps was to enable firms to take different risks and greater risks

than they could before deregulation started. Over the period from 1970 to 2007, the financial

industry experienced a metamorphosis that could not have occurred without deregulation. Firms

that had been stodgy, strictly regulated, and risk-averse, ultimately were able to transform

themselves into high flying risk takers because of the removal of regulatory restraints.

64. Quant Movement: The third deeper cause is the "quant movement"– the proliferation of

quantitative tools (particularly Monte Carlo simulations) for designing and analyzing financial

products, as well as for risk management. Of course, quantitative models themselves are rarely a

problem. It is over-reliance on such models or the intentional misuse of such models that causes

trouble.

65. One view is that the quant movement caused many finance professionals to mistakenly believe

that quantitative tools had allowed them to "conquer" risk. The FCIC report takes a slightly

more jaded view, implying that financial firms used quantitative tools for "risk justification"

rather than for true risk management.39

66. The heart of the problem associated with quantitative models was "model risk," the risk that a

model varies too much from the real world to produce useful results. Model risk might not have

been a problem if financial professionals had retained skepticism about the reliability of their

quantitative models. However, that was not the case. In fact, the (sometimes false) appearance

rigor and precision tended to encourage excessive reliance on such models.

67. The issue of model risk is hardly new. More than 10 years ago this writer offered the following

comment:

Our mathematical models generally will fail to capture the impact of rare and severe situations like

the attack on the World Trade Center. Their rareness makes them outliers and their severity

encourages us to discard them as aberrations. In building models, we allow ourselves to use

biased samples that overweight good times. We artificially simplify non-stationary processes. We

choose distribution forms that are convenient, even if their tails are too thin. If we find it too

difficult to quantify a seemingly relevant factor, we are prone to simply ignore it. Political and

social factors rarely appear as variables. And yet, all this is acceptable, provided that we

appreciate our models' limitations. We must not ask our models to carry more than they can bear.

Certainly, after 9/11, we have to have heightened sensitivity to such issues.40

68. Moreover, heavy reliance on quantitative methods – especially Monte Carlo simulations – for

finance did not suddenly arise in 2000. The quant movement has roots that run all the way back

to the Manhattan Project of the 1940s and through the game theory approaches to nuclear

strategy in the 1950s and 1960s. The introduction of desktop computers in the business

environment during the early 1980s brought with it the tools and approaches from these other

39

Id., p. xix.

40 Adelson, M., How the Events of 9/11 Affect Thinking About Risk, CMBS World, p. 59 (Summer 2002) (emphasis

in original, footnote omitted)

http://www.crefc.org/assetlibrary/ddf43bc8095d4d6ebda9bf8b57605659/d3fb0b37505042bd895def233af078671.pdf

or http://www.crefc.org/Magazine/CMBS_World_Summer_2002/index.html#/60/.


http://www.crefc.org/Magazine/CMBS_World_Summer_2002/index.html%23/60/



disciplines. Moreover, because of the rigor and apparent discipline of quantitative models, they

managed to gain even greater acceptance through the 1990s and early 2000s. Interestingly,

several notable failures, such as Long Term Capital Management's quantitative trading strategy

and the high losses in various structured finance sectors41

did not seem to dampen the market's

growing enthusiasm for quantitative methods.

69. Significantly, products and activities that relied heavily on quantitative models were at the heart

of how financial firms expanded their activities to take more and greater risks. Securitizations

and derivatives were conspicuous examples, but they were hardly the only ones.

70. Spread of Risk-Taking Culture into Traditionally Conservative Institutions: The fourth

deeper cause is the spread of risk-taking culture into traditionally conservative institutions. The

combination of the first three deeper causes, together with high compensation for professionals at

investment banks, caused other types of financial firms to seek to emulate the activities and

behaviors of investment banks. They wanted to copy the high compensation levels that trading

floor professionals at investment banks were receiving. Many commercial banks created

"Section 20" subsidiaries and branched into non-traditional "shadow banking" activities to

generate higher margins. Those non-traditional activities brought with them not just incremental

risk, but also complexity. In some cases, the activities themselves were benign, but they were

used to increase leverage through "off-balance sheet" accounting or similar means. The lowering

of regulatory firewalls allowed the behaviors to spread, and the quant movement provided a

justification that risk was being properly controlled.

71. The FCIC report notes that investment banks greatly increased employee compensation levels in

the 1980s and that commercial banks followed suit in order "to keep up."42

In a separate

passage, the report describes how, following the removal of regulatory constraints in the late

1990s, the desire of commercial banks and insurance companies to embrace investment banking

activities realized its full fruition:

The new regime encouraged growth and consolidation within and across banking, securities, and

insurance. The bank-centered financial holding companies … could compete directly with the

"big five" investment banks … in securitization, stock and bond underwriting, loan syndication,

and trading in over-the-counter (OTC) derivatives. The biggest bank holding companies became

major players in investment banking. The strategies of the largest commercial banks and their

holding companies came to more closely resemble the strategies of investment banks. Each had

advantages: commercial banks enjoyed greater access to insured deposits, and the investment

banks enjoyed less regulation. Both prospered from the late 1990s until the outbreak of the

financial crisis in 2007.43

72. Globalization: The fifth deeper cause is globalization. Globalization promoted the international

spread of high leverage and strong risk appetites among major financial firms throughout the

developed world. Two particular aspects of globalization stand out: (i) the partial

41

For a discussion of the losses in various structured finance sectors see Adelson, M., CDO and ABS

Underperformance: A Correlation Story, Journal of Fixed Income, vol. 13, no. 3, pp. 53-63 (Dec 2003).

42 FCIC Report, supra note 27, p. 62.

43 Id., p. 56.



homogenization of business cultures and practices, and (ii) the removal of capital controls among

the developed nations.

73. The removal of capital controls can be traced to the demise of the Bretton Woods system in

1971, when the U.S. dropped the gold standard. Until then, capital controls had somewhat

restrained international capital flows and may have served as barriers to the spread of capital

market contagion.44

With the removal of capital controls, financial firms throughout the

developed world became able to pursue the same strategies and take the same risks across

international boundaries.

74. The homogenization of business practices and cultures came about through advances in

computers, telecommunications and air travel. Domestic capital markets gave way to an

integrated global financial system. Financial professionals around the globe moved increasingly

toward wanting to pursue similar strategies. In the absence of capital controls, they could readily

do so. Thus, there are plentiful examples of non-U.S. financial firms expanding into risky non-

traditional products and using shadow banking activities increase economic leverage.

VI. Conclusion

75. The magnitude of the 2008 financial crisis is too big to be explained by the amount of losses on

U.S. residential mortgage loans. Rather, although mortgage losses may have served as a trigger

to unleash the crisis, its substantial proximate causes lie in the behaviors of financial firms;

namely high leverage and strong risk appetite. This is evident from the fact that many financial

firms either failed or nearly failed in the early phases of the crisis. However, the firms' behaviors

did not simply come out of the blue. They came from a variety of deeper causes, several of

which had roots stretching back several decades.

76. In the first volume of his history of the Second World War, Sir Winston Churchill starts his

exposition at the conclusion of First World War. He explains how the causes of WWII lie in a

sequence of events starting in 1919. After roughly three hundred pages of vivid history, he sums

up as follows:

Look back and see what we had successively accepted or thrown away: a Germany disarmed by a

solemn treaty; a Germany rearmed in violation of a solemn treaty; air superiority or even air parity

cast away; the Rhineland forcibly occupied and the Siegfried Line built or building; the Berlin-

Rome Axis established; Austria devoured and digested by the Reich; Czechoslovakia deserted and

ruined by the Munich Pact; its fortress line in German hands, its mighty arsenal of Skoda

henceforward making munitions for the German armies; President Roosevelt's effort to stabilize or

bring to a head the European situation by the intervention of the United States waved aside with

one hand, and Soviet Russia's undoubted willingness to join the Western Powers and go all lengths

to save Czechoslovakia ignored on the other; the services of thirty-five Czech divisions against the

44

This is somewhat different from the notion that capital controls and other forms of financial repression may

reduce the frequency of domestic financial crises. See Reinhart, C. and Rogoff, K., This Time is Different – Eight

Centuries of Financial Folly, Princeton University Press, p. 205 (2009); see also International Monetary Fund,

Articles of Agreement, Art. VI, §3 (as amended) (2008) http://www.imf.org/external/pubs/ft/aa/pdf/aa.pdf.

http://www.imf.org/external/pubs/ft/aa/pdf/aa.pdf



still unripened Germany [sic] Army cast away, when Great Britain could herself supply only two

to strengthen the front in France; all gone with the wind.45

77. So it is with the 2008 financial crisis. Despite the appeal of proximate causes as an explanation

for what happened, a real understanding can come only from probing for deeper causes. Those

causes are not simply recent, transient events, but rather major trends that persisted and gradually

changed the character of the financial industry over a period of decades.

78. Losses on U.S. residential mortgage loans were a result of the deeper causes. They were not

themselves a true cause of the crisis. The numbers simply don't support the conclusion that they

could have been.

VII. References

2011 Mortgage Market Statistical Annual, Inside Mortgage Finance Publications, vol. 2 (2011).

Adelson, M., CDO and ABS Underperformance: A Correlation Story, Journal of Fixed Income,

vol. 13, no. 3, pp. 53-63 (Dec 2003) (an earlier version of the article is available online at

http://www.securitization.net/pdf/nomura_what_051303.pdf or

http://www.markadelson.com/pubs/Model_Risk_2.pdf).

________, How the Events of 9/11 Affect Thinking About Risk, CMBS World, pp. 54-59, 78-79

(Summer 2002)

http://www.crefc.org/assetlibrary/ddf43bc8095d4d6ebda9bf8b57605659/d3fb0b37505042bd

895def233af078671.pdf or

http://www.crefc.org/Magazine/CMBS_World_Summer_2002/index.html#/60/.

Board of Governors of the Federal Reserve System, Flow of Funds Accounts of the United

States, Flows and Outstandings First Quarter 2008, Federal Reserve Statistical Release Z.1,

(5 Jun 2008) http://www.federalreserve.gov/releases/z1/20080605/z1.pdf.

________, The U.S. Housing Market: Current Conditions and Policy Considerations, white

paper (4 Jan 2012) http://www.federalreserve.gov/publications/other-reports/files/housing-

white-paper-20120104.pdf.

Briker, J., Kennickell, A., Moore, K., & Sabelhaus, Changes in U.S. Family Finances from 2007

to 2010: Evidence from the Survey of Consumer Finances, Federal Reserve Bulletin, vol. 98,

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