Too much right can make a wrong: Setting the stage for the financial crisis;

The financial crisis that started in 2007 exposed a number of flaws in the financial system. Many of these flaws were associated with financial instruments that were issued by the shadow banking system, especially securitized assets. The volume and complexity of securitized assets grew rapidly during runup to the financial crisis that began in 2007. The paper discusses how the financial crisis can be viewed as a possible but logical outcome of a system where investors are overconfident, busy, and investing other peoples’ money and intermediaries are set up to take advantage of investors’ tendencies. The investor-intermediary risk cycle in this crisis is common to other crises. However, there are a number of factors that may have made the 2007 crisis more severe. Among them are the length of the pre-crisis period, the shift from financial intermediaries to the shadow banking system, the increasing interconnectedness among financial firms, and the increased leverage at some financial firms. I would like to thank Crystal Cun for research assistance. These views in this paper are those of the author and may not represent the views of the Federal Reserve Bank of Chicago or the Federal Reserve System. Please address correspondence to Richard Rosen, Federal Reserve Bank of Chicago, phone 312322-6368, fax 312-294-6262, and email [email protected]. Too much right can make a wrong: Setting the stage for the financial crisis The financial crisis that began in 2007 may change the way firms and individuals borrow and save. The period leading up to the crisis was one where there was a rapidly expanding array of products that facilitated funds getting from savers to borrowers. At least in part because of these products, it became easy to borrow, leading to an expansion of debt (Figure 1 shows the growth in consumer indebtedness). In retrospect, it appears that many borrowers were given loans they should not have been or given loans at interest rates that were too low to reflect the riskiness of the loan. The financial crisis brought a swift halt to this. In this paper, I describe the changes that preceded the crisis, then examine why they occurred and how they may have contributed to the crisis. Much of the evolution of financial markets and institutions in recent years resulted in the movement of financing away from traditional bank lending (see, e.g., Adrian and Shin, 2009; Brunnermeier, 2009). Many of the new alternatives for borrowers and investors came, directly or indirectly, from what is sometimes called the shadow banking system (SBS). The SBS is the term used for financial institutions that provide alternatives to traditional bank financing. These firms can intermediate between borrowers and lenders, much as banks do. However, they offer a more complex array of products than just simple loans and they are often subject to less intensive regulation. As part of the move from bank financing to the SBS, one way that financial markets changed dramatically from the mid-1980s through the onset of the financial crisis in 2007 was the rise of structured finance. While there is no single definition of structured finance, here I focus mainly on securitization (most market participants consider credit derivatives and other structured risk transfer products as part of structured finance, see, e.g., Davis, 2005). Securitization is the issuance of bonds backed by the payments on a pool of assets. It allows banks and other lenders to originate assets without the need to hold them on their balance sheets for an extended period of time. The initial securitizations involved pools of home mortgages, with the bonds issued called mortgage-backed securities (MBS). MBS were soon followed by so-called asset-backed securities (ABS), which were bonds backed by the payments on pools of loans such as automobile and credit card loans. In the last twenty years, the types of assets that were part of securitizations expanded to include large corporate loans and mortgages as well as more obscure assets (there was a securitization backed by the royalties on recordings by David Bowie). There have also been securitizations that are backed by the payments on pools of securitized bonds from different deals (collateralized debt obligations, or CDOs). The ability of lenders to easily sell loans into securitizations made the “originate-to-distribute” (OTD) business model possible. Instead of making a loan and holding it on its balance sheet until maturity, a lender could make (originate) a loan, then immediately sell it. 1 The SBS is a slightly more expansive definition of non-bank alternatives then, for example, the securitized banking sector referred to by Gorton and Metrick (2009) and the market-based financial intermediation in Shleifer and Vishny (2009). 2 The types of firms that are included as part of the SBS include investment banks, hedge funds, monoline insurance companies, the government-sponsored entities (GSEs), and a number of specialized entities that are set up to issue derivative financial securities. Banks can be part of the SBS to the extent that they participate in financing different from traditional lending. I discuss the purchase of securities created in the SBS below.