by Swaminathan S. Anklesaria Aiyar
Dated: October 22, 2008
Leftists claim that the global financial crisis was caused by reckless
deregulation and greed. Rightists blame half-baked financial
regulations and perverse incentives. Actually, the financial sector is
deeply regulated, with major roles for both the state and markets. It
was not one or the other that failed but the combination.
The best metaphor for the mess comes from Jack and Suzy Welch, who
recall Agatha Christie's "Murder on the Orient Express." In this
novel, 12 people are suspects in a murder. And 12 turn out to be
guilty. What starts as a whodunit concludes as an everybody-dun-it.
In the same spirit, allow me to present the 12 murderers of the US
1. The Federal Reserve Board. Alan Greenspan, Fed Governor in
1987-2006, was once hailed as a genius for keeping the US booming, but
is now called a serial bubble-maker. He presided over bubbles in
housing, credit, and stock markets. He said it was difficult to
identify asset bubbles in advance, so anti-bubble policies might be
anti-growth. It was better to let bubbles build, and sweep up after
they burst. Bernanke, like Greenspan, ignored the US housing bubble
till it burst.
2.US politicians. Envisioning a home for every American, regardless of
income, they provided excess implicit and explicit housing subsidies.
One law forced banks to lend to sub-prime poor borrowers. Legislators
created Fannie Mae and Freddie Mac, government-sponsored entities that
bought or underwrote 80% of all US mortgages, and enjoyed exemption
from normal regulations. Politicians ignored Greenspan's warning that
such a dominant role for two under-regulated giants posed a huge
3.Fannie Mae and Freddie Mac. They resisted regulation, and spent over
$ 2 million lobbying legislators against any tightening of rules. As
mortgagers of last resort they should have been especially prudent.
But they bought stacks of toxic mortgage paper—collateralized debt
obligations (CDOs)—seeking short-term profits that ultimately led to
4.Financial innovators. Their ideas provided cheap, easy credit, and
helped stoke the global economic boom of 2003-08. Securitisation of
mortgages provided an avalanche of capital for banks and mortgage
companies to lend afresh. Unfortunately the new instruments were so
complex that not even bankers realized their full risks. CDOs smuggled
BBB mortgages into AAA securities, leaving investors with huge
quantities of down-rated paper when the housing bubble burst.
Financial innovators created Credit Default Swaps (CDSs), which
insured bonds against default. CDS issues swelled to a mind-boggling $
60 trillion. When markets fell and defaults widened, those holding
CDSs faced disaster.
5.Regulators. All major countries had regulators for banking,
insurance and financial/ stock markets. These were asleep at the
wheel. No insurance regulator sought to check the runaway growth of
the CDS market, or impose normal regulatory checks like capital
adequacy. No financial regulator saw or checked the inherent risks in
complex derivatives. Leftists today demand more regulations, but these
will not thwart the next crisis if regulators stay asleep.
6.Banks and mortgage lenders. Instead of keeping mortgages on their
own books, lenders packaged these into securities and sold them. So,
they no longer had incentives to thoroughly check the creditworthiness
of borrowers. Lending norms were constantly eased. Ultimately, banks
were giving loans to people with no verification of income, jobs or
assets. Some banks offered teaser loans—low starting interest rates,
which reset at much higher levels in later years—to lure unsuspecting
7.Investment banks. Once, these institutions provided financial
services such as underwriting, wealth management, and assistance with
IPOs and mergers and acquisition. But more recently they began using
borrowed money—with leverage of up to 30 times—to trade on their own
account. Deservedly, all five top investment banks have disappeared.
Lehman Brothers is bust, Bear Stearns and Merrill Lynch have acquired
by banks, and Morgan Stanley and Goldman Sachs have been converted
into regular banks.
8.Rating agencies. Moody's and Standard and Poor's were not tough or
alert enough to spot the rise in risk as leverage skyrocketed. They
allowed BBB mortgages to be laundered into AAA mortgages through CDOs.
9.The Basle rules for banks. These international negotiated norms
provided harmonized regulatory checks on financial excesses across
countries. The first set of norms, Basle-I, was widely criticized as
too rigid and blunt. So countries agreed on Basle-II, which allowed
banks to use credit ratings and models based on historical record to
lower the risk-ratings of many securities. This dilution of norms led
to excesses everywhere. Iceland's banks went bust holding
loans/securities totaling 10 times its GDP. The dilution of
risk-rating in Basle-II helped inflate the financial bubble.
10.US consumers. Their savings used to be 6% of disposable income some
time ago, but more recently has been zero or even negative. They have
gone on a huge borrowing spree to spend far more than they earn. This
excess is reflected in huge, unsustainable US trade deficits.
11.Asian and OPEC countries. They undervalued their currencies to
stimulate exports and create large trade surpluses with the US. They
accumulated trillions in forex reserves, and put these mostly into
dollar securities. This depressed US interest rates, and further
fuelled borrowing there.
12.Everybody. Consumers, corporations, banks, politicians, the
media--indeed everybody-- was happy when housing prices boomed, stock
markets boomed, and credit became cheap and easily available. Bubbles
in all these areas grew in full public view. They were highlighted by
analysts, but nobody wanted to stop the lovely party. Everybody liked
easy money and rising asset prices. This trumped prudence across
So, forget the left-versus-right or regulations-versus-markets debate
on the financial crisis. States, institutions, markets and everybody
else was guilty. These actors will for some years don sackcloth and
ashes, adopt stiffer regulations, and listen to lectures on the
virtues of prudence and restraint. But after seven to ten years of the
next business upswing, I predict that we will once again have a new
generation of bubbles, evading whatever new checks have been put in
place. When everybody loves bubbles, they are both irresistible and