Sunday, September 19, 2010

Causes of the US Economic & Financial Crisis in 2008 - Alpha

by Alpha and Vega, an Investor and a Trader
September 19th, 2010

In this issue:
1) A difficult question
2) Long-term structural economic problems
3) Short term catalysts for the financial crash
4) Bluto’s revenge in the movie “Animal House”

In this letter we answer the question: “What caused the US economic and financial crisis in 2008?” We look at long-term structural causes and short-term catalysts. This is a longer piece than most, and we try to present many arguments, data points, and references for further reading.

1) A difficult question

What caused the US economic and financial crisis in 2008?

Whatever it was, it was enough to cause former Fed Chairman Alan Greenspan, a free-market disciple of Ayn Rand, to sit in front of a Congressional panel and admit, while squirming in front of lights and TV cameras: “This crisis has turned out to be much broader than anything I could have imagined. It has morphed from one gripped by liquidity restraints to one in which fears of insolvency are now paramount. . . I don’t know how significant or permanent [the flaw in my ideology] is. But I’ve been very distressed by that fact.” Greenspan was one of the few intellectually honest people in admitting his own ignorance and error.

Greenspan Admits Mistakes in 2008 (Testifying to Congress in 2008)

No one has given a cogent, comprehensive answer that is brief and non-technical. Economists have responded like ducks by sticking their head in the water and blaming one another, with debates between “saltwater” and “freshwater” economists. Historians point to disparate episodes and facts like the Great Depression and Asian Crisis of 1998 (while ignoring the US depression of 1870-1890 and the Japanese balance sheet recession of 1990-2008). Financial experts point to short-term catalysts and trends, like MBS or CDO issuance and the failure of ABCP or money markets (acronyms are one tool Wall Street uses to screw people); but these experts ignore the big picture.

This letter will attempt an explanation for what caused the 2008 crisis in the US while acknowledging its global context. I shall also link the insight that numerous thinkers and writers have brought to the issue and try to frame a robust answer. For further reading beyond the books and articles in this letter’s references, the St. Louis Fed has a nice repository of academic articles about the US financial crisis (and a first-rate glossary).

Two types of problems created the crisis. First were deeper, long-term structural problems, such as:

a) Too much total debt accumulation per person and per unit of GDP from1980-2007
b) Looming structural deficits from Medicare and Social Security (off-balance sheet debt) make the US even more insolvent
c) Consistent trade deficits powered by the US’s reserve currency status, an undervalued Chinese yuan, and the resulting decline of the US export and manufacturing bases:
d) A financial industry acting as a giant tax on the US: Too much deregulation of financial markets, leading to spurious innovation that enriches the financial sector at the expense of consumers (corporate and retail)
e) A massively inefficient tax code, with too many complex rules and hidden “tax expenditure” subsidies to wasteful interest groups
f) Resources wasted on two wars (2002-2008) and US military protection for the rest of the world

Most politicians, economists, and the news media personalities have tried to conceal the structural economic problems of the US rather than honestly deal with them. Within the structural environment of economic degradation, there came second a group of short-term catalysts. When these combined, they were toxic and led to a period of financial fragility from 2007 on and a tipping point in September 2008:

a) Low interest rates and weak mortgage regulation: this enables speculation leading to the mortgage boom and real estate bubble
b) Bad bank balance sheets due to excessive risk-taking and agency costs: Weakening regulation of large banks causes re-consolidation and dangerous investment bank debt levels
c) Black-box derivatives: The development of a complicated and unstable, even destabilizing, derivatives market
d) The trader mentality in the US: The short-term price appreciation and momentum mentality of professional investors versus long-term yield oriented mentality (average holding period for stocks has fallen from 8-10 years (pre-1960 average) to 4 years (pre-1980 average) to about six months in 2007. Very few investors left (some VCs and corporate investors).
e) Extreme financial fragility through 2007 into 2008:
-Early signs: Bear Stearns hedge funds blowing up and the implosion of the shadow banking system (an old fashioned bank run)
-Inflection Point: From Bear Stearns going bankrupt in March 2008 to the failure of insolvent Fannie/Freddie in early September 2008 – largest financial institutions in the US (maybe the world) based not on their actual balance sheet, but their guarantee liability for mortgages (above $5 trillion combined)
-Phase Shift: Failure of insolvent Lehman Brothers and illiquid AIG causes phase shift in markets in late September 2008

To read the full letter, please see the pdf on Scribd here:
Causes of the 2008 US Economic and Financial Crisis (Sept. 2010)

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