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No doubt, economic historians will argue for years to come
about the causes of the global financial crisis. The primary
causal factor was macroeconomic, but appropriate regulation
might have averted or ameliorated the crisis.
Joel P. Trachtman is professor of international law at
the Fletcher School of Law and Diplomacy, Tufts University.
His publications include The Economic Structure of
International Law and International Law and Politics.
T
he global financial crisis has eclipsed Iraq,
Afghanistan, North Korea, and other crises as a
topic of concern — making these critical threats
to global stability seem modest by comparison. Even
if our perception is myopic and too greatly focused on
our pocketbooks, the global financial crisis is significant,
and it has spread to many places around the world. In
order to address the current crisis and to prevent future
crises — if, indeed, that is possible — it is necessary to
understand what caused this crisis. Diagnosis is not easy
because this crisis was caused by a complex interaction of
macroeconomic mismanagement, incomplete financial
regulation, and defective corporate governance. For the
same reason, prevention of future crises is not a simple
matter.
The financial crisis began in the United States with
a housing price bubble and risky mortgages. Mortgages
seemed like solid investments while housing prices
rose, but looked much less attractive as housing prices
declined. And this decline fed on itself, as reduced
willingness to lend and foreclosures on mortgages caused
further reductions in home prices. Many of the original
Global Financial Trouble:
Causes, Cures, Responses
Joel P. Trachtman
A currency trader at the Korea Exchange Bank in Seoul, South Korea,April 9, 2009.
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mortgages were securitized, and banks and other financial
institutions, as well as investors, eagerly purchased and
traded the resulting securities in their never-ending
search for high-yielding investments. But the holders of
these securities found that their value declined sharply.
For financial institutions, the losses on these securities
impaired their capital and their ability to do business.
This reduced their ability to finance businesses, resulting
in a substantial depressing effect on the real economy. The
credit freeze is only now showing signs of thawing.
While the crisis began in the United States, it is now
global. It became global because the financial system is
global, and the financial institutions that engaged in the
subprime mortgage business in the United States included
both U.S. multinationals and foreign multinationals.
In addition, some foreign financial institutions did
similar businesses abroad, emulating the U.S. domestic
experience. Financial contagion meant that as the first,
mostly U.S., financial institutions were threatened with
failure, their counterparts around the world were also
threatened. Finally, economic contagion through trade and
investment has brought a sharp reduction in exports to the
United States and in investment abroad from the United
States.
THE CAUSES
No doubt, economic historians will argue for years to
come about the causes of the global financial crisis. The
primary causal factor was macroeconomic, but appropriate
regulation might have averted or ameliorated the crisis.
Low interest rates in the United States, Japan, and
elsewhere, China’s exchange rate policies, and the growth
of oil wealth and other wealth in sovereign wealth
funds all contributed to excess liquidity, which in turn
contributed to the development of an asset bubble. There
was a lot of cheap money around, and it needed to be
reinvested. Not only that, but because there was a lot of
cheap money, investors were constantly seeking increased
returns. Those who promised them higher returns could
command great followings and fees.
Much of this excess liquidity flowed into U.S.
housing. During the run-up to the crisis, U.S. housing
had the characteristics of a classic bubble. Those who
invested in housing, either as owners or as lenders, looked
like financial geniuses. Mortgage lenders could not really
lose money because the value of their collateral would
continue to rise, forgiving lending mistakes. As legendary
investor Warren Buffett has said, “It’s only when the tide
goes out that you learn who’s been swimming naked.”
Mortgage lenders were no longer the traditional
local savings and loan associations, planning to hold the
mortgage loans that they originated until maturity. Rather,
these loans were packaged into pools and these pools were
securitized, with individual investors and merchant banks
trading in and investing in these securities. Therefore,
the mortgage lenders often did not take a long-term view
and did not worry about the ability of their borrowers
to service their mortgages in a financial downturn. The
amount of mortgage-backed securities issued skyrocketed
beginning in late 2003. The profit model for many
financial institutions had changed from one based on
interest rate spreads to one based on fees and trading. This
changing business model also brought with it changes in
compensation — providing bonuses for executives who
were able to produce these fees and trading profits.
Securitization required good pools of loans, according
to the underwriting requirements specified, and it also
often required credit enhancements through insurance
or other backing. These mortgage-backed securities,
meeting the requirements specified by rating agencies
such as Moody’s and Standard & Poor’s, generally received
top credit ratings. The rating agencies competed with
one another for business and often relied on historical
experience, rather than on forward-looking models that
included the possibility of an asset bubble, to determine
the creditworthiness of these pools.
The U.S. regulatory structure may be accused of
both sins of commission and sins of omission. The
The currencies of the United States and China.
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Bush administration sought to extend home ownership
to lower-income people through zero-equity lending.
Increased capital requirements imposed on U.S.
mortgage giants Fannie Mae (Federal National Mortgage
Association) and Freddie Mac (Federal Home Loan
Mortgage Corporation) opened the home financing
market to securitization by other institutions. The Basel
capital requirements provided incentives for securitization,
and the expected reduction in capital requirements
relating to mortgages under Basel II induced U.S. banks
to increase their holdings of mortgage-backed securities.
Investment banks were permitted to increase their
leverage. All of these regulatory changes may be said to
have been driven by the available liquidity and to have
accentuated the growth of the mortgage-backed securities
market and of its risks. While individual regulators may
have seen some of the problems growing, the authorities
lacked the political will to intervene strongly.
The corporate governance of many financial
institutions was placed under severe stress by the fee and
trading-based model, the drive to promote businesses that
produced greater profits, the competitive pressure resulting
from other firms’ risky activities, and the inability to
develop a persuasive model of long-term risk. Under
these circumstances, shareholders, boards of directors,
and senior management were unable to assess and curtail
the risk that their institutions absorbed. In congressional
testimony in October 2008, Alan Greenspan, former
chairman of the U.S. Federal Reserve Bank, stated that
“those of us who have who looked to the self-interest
of lending institutions to protect shareholder’s equity
— myself especially — are now in a state of shocked
disbelief.” This is a stunning indictment of American
corporate governance: The mechanisms of corporate
governance are insufficient to ensure that executives will
manage in the long-run interests of shareholders, rather
than in their own short-run interest.
THE CURES
Each of the causes of the financial crisis will merit
careful consideration in order to prevent future crises.
Of course, we need to remember that mere retrospective
prevention of crises like those we have already experienced,
such as the French military’s Maginot Line in World
War II, will not prevent future crises. Rather, we must
understand the types of structures that cause crisis, and
seek to establish mechanisms to see new crises coming and
to restructure our regulation to respond.
First, macroeconomic management must be able to
identify asset bubbles and to muster the political will to
respond. Second, we must be careful to recognize that
regulatory reforms often have pro-cyclical motivations:
accentuating dangerous phenomena. As we engage in
regulatory reform, we must be careful to ask the Warren
Buffett question: Will we be seen to be naked when
the tide goes out? Third, financial regulation must
be understood as a special response to the particular
incentive incompatibilities of financial institutions. We
must recognize that corporate governance alone can be
inadequate to restrain short-sighted management. We also
must recognize that shareholders of financial institutions
may themselves have inadequate incentives to ensure
that financial institutions avoid excess risk: The rest of us
may, through deposit insurance and government bailouts,
absorb significant components of the risk. This moral
hazard often requires a regulatory response.
REQUIRED RESPONSES
Domestic regulation is often needed when firms do
not bear all the risks of their actions or when the people
who control firms do not bear all the risks of their actions.
Furthermore, international regulation is needed when
states do not bear all the risks of their regulatory actions.
International externalities may occur through contagion:
Financial institutions maintain dense international webs
of interbank relationships, and the failure of one bank
may hurt others. International externalities may also
Former Fannie Mae chief executives testify before U.S. congressional
committees, December 2008.
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occur through regulatory competition: When one state
reduces its standards, it may increase the short-term
competitiveness of its financial institutions, imposing
competitive harm on foreign financial institutions. Finally,
a U.S. economic slump has repercussions around the
world through the mechanism of trade and investment.
What kind of international regulatory response is
required? States must take greater responsibility for the
solvency regulation of their financial institutions in order
to limit the risk of contagion. It may be appropriate for
states to agree on the scope of this responsibility.
But this will not be enough. Corporate governance
problems that induce firms to take excessive risk must
be addressed, either through regulation or through selfregulation
by the financial industry. An international
regulatory response will be needed to ensure that states
do not have incentives to reduce regulation in order to
promote the competitiveness of their own firms. The Basel
capital regulation was partially motivated by this concern,
but much more work needs to be done.
Finally, greater sobriety and humility in
macroeconomic management, and greater attention to the
concerns of other states regarding national macroeconomic
management, will be needed in order to avoid the
conditions for asset bubbles or other macroeconomicbased
crises.
The opinions expressed in this article do not necessarily reflect the views or
policies of the U.S. government.
As homeowners default on mortgages,“For Sale” signs pop up on the street.
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