There’s already been much discussion over what fueled the Great Recession of 2008 . In this video, Tyler Cowen focuses on a central theme of the crisis: the failure

There’s already been much discussion over what fueled the Great Recession of 2008. In this video, Tyler Cowen focuses on a central theme of the crisis: the failure of financial intermediaries.

By 2008, the economy was in a very fragile state, with both homeowners and banks taking on greater leverage, many ending up “underwater.” Why did managers at financial institutions take on greater and greater risk? We’ll discuss a couple of key reasons, including the role of excess confidence and incentives.

In addition to homeowners’ leverage and bank leverage, a third factor played a major role in tipping the scale toward crisis: securitization. Mortgage securities during this time were very hard to value, riskier than advertised, and filled to the brim with high risk loans. Cowen discusses several reasons this happened, including downright fraud, failure of credit rating agencies, and overconfidence in the American housing market.

Finally, a fourth factor joins homeowners’ leverage, bank leverage, and securitization to inch the economy closer to the edge: the shadow banking system. On the whole, the shadow banking system is made up of investment banks and various other complex financial intermediaries, highly dependent on short term loans.

When housing prices started to fall in 2007, it was the final nudge that pushed the economy over the cliff. There was a run on the shadow banking system. Financial intermediaries came crashing down. We faced a credit crunch, and many businesses stopped growing. Layoffs ensued, increasing unemployment.

What could have been done to prevent all of this? You’ll have to watch the video to find out.

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A lot of ink already has been spilt discussing the Great Recession of 2008. And a full examination of that would require a lot more than just one video. So today, I'm going to limit our discussion to just one central theme of the crisis, namely financial intermediation.


Let's say you're buying a home that costs $100,000. A typical down payment might have been, say, 20%, and that would mean your mortgage was for 80% of the home value, or $80,000. Now in the lead up to the crisis, many homes were being purchased with much less than 20% down -- 10% down or 5% down. Or in a lot of cases, nothing was put down at all -- zero down. When you put money down on a house, that creates a kind of protective cushion. Now, the difference between the value of the house and the unpaid amount of the mortgage -- that's called "owner's equity." So now, when you first buy a house, your down payment is your owner's equity.

Over time, as you pay down your mortgage and if your home value goes up, well, in those cases, your owner's equity rises and that makes the protective cushion bigger. The ratio of debt to equity, which represents how much of a protective cushion is in a home or in a company -- that's called the "leverage ratio." So, a 5% down payment on a $100,000 house would mean you'd have $5,000 in owner's equity, which when compared to the mortgage of $95,000, would give you a leverage ratio of 19.


So, what's the effect of high leverage? It means there's very little room for the price on your home to drop before the value of your house is less than the unpaid mortgage amount. That is, if you needed to sell the home to pay off your mortgage, the proceeds from the house sale would not be enough to pay off the bank. Being under water is clearly not good for the individual home owner. But very importantly, it's also not good for the bank. In the case of foreclosure, say the homeowner cannot keep on paying the mortgage. Well the bank is getting a home but the home isn't worth enough. The bank loses money because the value of the home is less than what the bank was expecting to receive from the home owner in the form of mortgage payments.


So again, back to the broader picture. It wasn't just home owners who were using more leverage. Banks were using more leverage. They were buying assets using more debt and less of their own cash. So, what we're doing here is stacking problems: the problem of the home owner's leverage, the problem of the bank leverage. And the more problems like these you stack, the more financial fragility you're bringing into the economy. Now in 2004, the investment bank Lehman Brothers -- it had a leverage ratio of about 20. But it continued to borrow more money. And by 2007, that leverage ratio went as high as 44. Now in that setting, if Lehman Brothers sees its assets fall in value very quickly, Lehman Brothers too will in essence be under water. That is the assets of the company will be worth less than the debt the company owes. In other words, in that case, the company would be insolvent. This sounds like such a terrible state of affairs.


So, you have to wonder "Why would the experienced managers of a large firm like Lehman Brothers have been so risky?" There are a few reasons, but the first and most important reason was just sheer excess confidence. Those managers bought mortgage securities and they made other risky investments. But the managers, like indeed most other people, they just didn't think that American home prices could fall so much. And they also didn't understand that a fall in home prices could potentially create so much turmoil in American capital markets. Another key factor behind the failure was incentives.


The managers at Lehman -- they got big bonuses based on the profits of the company. And in some cases, this can lead managers to take on too much risk. How does that work? Well think about it. Bigger profits typically meant bigger bonuses. So, if you go from a leverage ratio of 20 to 44, as Lehman Brothers did, that means you can buy more than double the amount of assets with the same amount of initial capital, because you're using more debt. That means more than double the profit if asset prices rise as indeed they had been doing.


But what if the assets fall in value? What if the initial risk does turn out badly? And you have to ask when the asset prices did fall and Lehman Brothers went bankrupt, did the managers also personally go bankrupt? No, they did not. They still, for the most part, had a lot of money in their bank accounts. So, in this setting, Lehman managers had a lot to gain if things would go well, but they faced only limited downside in the scenario where things would go sour.


Let's add another factor to this mix that ended up pushing the economy even a bit closer toward the edge of the cliff, and that additional factor was securitization. So how does securitization work? Briefly, individual mortgages are bundled together and sold to outside parties as liquid financial assets. So, rather than lending a company money directly, as you would do with a bond, you buy a mortgage security, and indirectly you provide money to people who use it to buy homes. So, it turned out there were all these securities out there which were very hard to value, many of them were riskier than advertised, and many of them were just bad outright, filled with too many high-risk loans.


How is it that this happened? Well there were a few factors. Sometimes the problem was outright fraud in terms of how the security was sold and how it was explained. Or sometimes it was a failure of the rating agencies, which were supposed to assess risk more or less accurately, but they performed poorly. But probably the biggest single problem was again a kind of complacency. Most people incorrectly assumed American housing was really quite a safe investment, and that prices would either continue to rise, or at the very least hold fairly stable.


One final factor set the stage and brought all of this together, and that's what is called the shadow banking system. So, what does that mean? Well here I need to give some terminology. What you and I commonly would just call a bank is actually more technically a commercial bank. And that means a bank that takes deposits from individuals and businesses and it's insured by the government through the FDIC. Because of the government guarantee, depositors don't feel the need to run to the bank at the first sign of trouble and pull out their money.


Now investment banks -- they're different. Investment banks, like Lehman Brothers, were a different kind of bank without a comparable governmental guarantee for deposits or liabilities. The money they used -- it came from investors, not from depositors. So, the investors were always asking, "If I lend to an investment bank, are my funds safe? Will I get my money back?" And these investors were more watchful and sometimes even prone to panic if something seemed to be wrong with the investment bank.


Now the shadow banking system as a whole is made up of investment banks along with other complex financial intermediaries, such as hedge funds, issuers of asset-backed securities like the mortgage bonds discussed earlier, money market funds, and even some parts of traditional commercial banks, which are not covered by the deposit insurance guarantee. So, in that setting, by the year 2008, the shadow banking system actually was lending considerably more than were traditional commercial banks.


So, we've got highly leveraged houses and banks, banks and other investors holding risky mortgage securities, and a massive shadow banking system highly dependent on short-term loans, which in turn were dependent on investor confidence. This was the proverbial case of being very close to the cliff and needing only an extra nudge to fall off. And that nudge came in 2007 when housing prices started to fall, causing many home owners to be under water. This meant that the assets owned by banks, such as mortgage-backed securities, were dropping in value. Remember, banks were highly leveraged too.


So, this fall in asset values pushed many banks closer to insolvency. Worse yet, the complexity of investments in mortgage-backed securities obscured how much exposure particular banks faced. The market started to think of virtually all banks as really quite risky, and this exacerbated the financial crisis. The investors who provided the short-term loans to fund the shadow banking system -- well, they fled to safety. They pulled their capital away from these short-term loans to investment banks such as Lehman Brothers, and this run on the shadow banking system was similar to the runs on traditional commercial banks by depositors, as seen in America's Great Depression. And that was a time when even bank deposits were not insured by the government. Without these short-term loans, investment banks and other financial institutions -- they were starved of the money they needed to function.


They couldn't keep on making loans of their own and so they started selling their own assets to get operating funds just to stay up and running. But that leads to yet another problem. When a lot of financial institutions are all selling assets at the same time, you end up with what's called a fire sale. As they all sell, that selling pushes asset prices lower -- even lower. And those lower asset values -- that pushes even more financial institutions closer toward bankruptcy. So, financial intermediaries came crashing down and this led to a credit crunch that damaged the entire economy. In this setting, many businesses that depended on credit -- they failed or they stopped growing. Maybe they laid off workers to conserve cash and unemployment spiked.


So, looking back we have to ask, "What could have been done? What should have been done?" It's now considered a general problem that short-term loans for the shadow banking system can flee rapidly in times of crisis and cause widespread financial and economic turmoil. So, what to do? In response to this, some suggest a similar solution to what we did for runs on traditional commercial banks, namely a government guarantee of some, or all, of those liabilities.


However, that's a pretty radical step. It would put an even larger potential burden on taxpayers, maybe trillions. And it also doesn't fix the incentive problems I mentioned earlier, namely that when there’s leverage, and especially guaranteed liabilities, the managers have an incentive to take too much risk. It would make that problem worse. Since the financial crisis, other regulations have been enacted to cover the shadow banking system, and also traditional banks. Those regulations require more equity and less leverage. And that makes sense in terms of my earlier discussion of needing a larger financial protective cushion. Still, it remains to be seen just how effective these regulations will prove. So, far there's been no market turmoil comparable to the crisis of 2008. So, we just don't know exactly how well the new institutions will work.


There's a lot more to cover on the Great Recession. And if you're interested in learning more, please just let us know. Thanks.