I happened to catch Bill Clinton on the Late Show with David Letterman earlier this month and was surprised at how much substance was contained in the interview. I encourage you to read the full text of Clinton’s explanation of the causes of the credit crisis, as it is concise, straightforward and relatively accessible.
But is it correct? Clinton generally perceives the broader credit crisis as an issue of too much money floating around without enough good investment opportunities for it to flow into. Clinton touches on the fact that the Fed kept interest rates low following the burst of the tech bubble, in an effort to keep economic activity going and prevent a recession. This cheap money then flowed into residential real estate, which Clinton says was the only sector of the economy demonstrating real growth – 40-50% in the first five years after 2001. This overinvestment in real estate, combined with an increase in leverage and insufficient regulation was what caused this crisis, according to Clinton. In other words, it was a problem of incentives.
I ran this explanation by a number of my friends in the investment banking and hedge fund world over the weekend, and they generally agreed that the driving force behind this crisis was an improper incentive structure, and a resulting liquidity crisis when housing prices began to level off. But they placed the blame much more squarely in the court of the federal government, something Clinton tried to downplay.
For one, keeping interest rates low after the bursting of the tech bubble makes perfect sense to help stimulate investment and prevent recession. But, at some point, those interest rates have to be normalized, otherwise the cheap cash leads to overinvestment in risky ventures, e.g. subprime mortgages.
Moreover, a number of government programs provided incentives for potentially unqualified people to take out mortgages, including tax breaks for homeownership, legislation encouraging lending to minorities and low-income borrowers, and the rise of subprime lending and its concomitant looser lending guidelines. All the while, there was a ready secondary market for mortgage-backed securities and other derivatives based on such loans, provided by quasi-governmental enterprises Fannie Mae and Freddie Mac.
My banking friends thus came to generally the same conclusion that Clinton did – this was a problem of perverse incentives – but felt these incentives were fueled in large part by the government. Naturally, they defended financial institutions by arguing that if one lender did not make that loan to Mr. Unqualified Borrower, someone else would. As a famous financial maxim goes, “the markets can stay irrational a lot longer than you can stay solvent.”
Now, this is not to say that lenders and borrowers did not play a role by participating in ill-advised or ill-intentioned loans. I’ve made the point several times that this system would not have collapsed so completely had the foundation been built on sound lending. But, we can’t expect financial institutions to make moral decisions – they are institutions that operate to maximize profits. It is up to government to legislate and enforce the law to properly incentivize institutions to act within legal limits. As is becoming more readily apparent, in order to fix this crisis and prevent it from reoccurring, we must start from the top-down by creating a market with the proper incentives and making sure government is working to encourage sound investment.