The Deeper Causes of the Financial Crisis: Mortgages Alone Cannot Explain It Crisis: Mortgages Alone Cannot Explain It M ... the impact of the financial crisis. Although losses on

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  • 16 THE DEEPER CAUSES OF THE FINANCIAL CRISIS: MORTGAGES ALONE CANNOT EXPLAIN IT SPRING 2013

    The Deeper Causes of the Financial Crisis: Mortgages Alone Cannot Explain ItMARK ADELSON

    MARK ADELSONis chief strategy officer at The BondFactor Company, LLC, in New York, NY.madelson@bondfactor.com

    The all-in cost of the 2008 global financial crisis is huge. It must be reckoned in trillions of dollars, with numbers so big that they seem more at home in a discussion of physics or astronomy than in finance. Depending on how its measured, the cost of the crisis appears to fall between $5 trillion and $15 trillion. For example, one measure of the cost is the decline in the aggregate value of the worlds stock mar-kets. After an initial drop of more than $35 trillion, the worlds stock markets have lev-eled off at between $10 trillion and $12 trillion below the pre-crisis peak.

    By comparison, the losses on U.S. resi-dential mortgage loans at the onset of the crisis, including both already-realized losses and those yet to come, appear modest. This article estimates that all-in losses are between $750 billion and $2 trillion. Those are big num-bersbut not nearly big enough to explain the impact of the financial crisis. Although losses on residential mortgage loans may have served as the spark that ignited a powder keg of true underlying causes, the mortgage losses themselves are not one of the true causes.

    If mortgage losses cannot explain the financial crisis, what can? The immediate causes seem to be financial firm behaviors, particularly high leverage and strong risk appetite. This assertion isnt a great leap; a significant number of major financial f irms failed or

    nearly failed in the early years of the crisis. However, identifying the immediate causes is only partly satisfying. It begs the question of what were their underlying drivers; what were the deeper causes? This article suggests five deeper causes.

    In contrast to other articles that empha-size the immediate causes of the f inancial crisis, this one explores deeper causes, which all have roots stretching back decades. In other words, the foundations of the 2008 financial crisis were not laid in the early- or mid-2000s, but rather in the 1970s, 1980s, and 1990s.

    An issue as large as the financial crisis nat-urally intersects with other, contemporaneous economic issues. An examination of the finan-cial crisis might naturally stray into considering such issues. This article, however, focuses solely on the 2008 financial crisis, steering clear of issues that include the U.S fiscal imbalance, the European sovereign debt crisis, ongoing economic stagnation in Japan, and developing asset bubbles in China. Including those issues in this discussion would add little substance to the analysis and would make the discussion far too lengthy.

    This article is organized into six parts. The first is this introduction. The second part attempts to measure the magnitude of the financial crisis a few different ways. The third part addresses losses from defaults on U.S. resi-dential mortgage loans. The fourth considers

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    the immediate causes of the crisis, and the fifth suggests five deeper causes. The sixth part concludes.

    THE COST OF THE FINANCIAL CRISIS

    Reckoning the real cost of the financial crisis is a difficult matter. By any reasonable approach, it amounts to many trillions of dollars. The following discussion considers several approaches for quantifying the cost. Most of the approaches are incomplete. They capture only a single dimension of the cost of the financial crisis or they cover only a limited geographic region. None covers the full cost on a global basis.

    Market Capitalization

    One way of measuring is to look at the aggregate market capitalization of the worlds equity exchanges, where the crisis brought about a temporary decline of roughly $37 trillion. After a partial recovery, the per-sisting erosion of equity values remains between $10 trillion and $12 trillion.

    As shown in Exhibit 1, the market capitalization of the worlds equity markets peaked at roughly $62.5 tril-lion in the fourth quarter of 2007 and declined to a low of roughly $25.5 trillion in the first quarter of 2009. The

    decline represented an erosion of roughly $37 trillion of equity value. The market capitalization subsequently recovered some of the lost ground, reaching $50 trillion in the fourth quarter of 2010. Since then, it has f luctu-ated between roughly $45 trillion and $55 trillion, so the world equity markets have a longer-term an erosion of roughly $10 trillion to $12 trillion of equity value.

    World GDP

    A second way to consider the cost of the financial crisis is in terms of the impact on world GDP. World GDP contracted by roughly $3 trillion in 2009, relative to 2008. That amounted to a 5.25 percent decline, by far the largest drop since 1960. In the 48-year period from 1960 to 2008, world GDP declined in only four years (1982, 1997, 1998, and 2001), and the largest percentage decline in any of those years was 0.96 percent in 1982. Against that background, a 5.25 percent decline in 2009 is remarkable.

    Exhibit 2 shows the data as compiled by the World Bank. World GDP reached approximately $61.3 tril-lion in 2008 before declining to $58.1 trillion in 2009. Growth returned in 2010, with world GDP advancing to $63.3 trillion.

    E X H I B I T 1Bloomberg World Exchange Market Capitalization

    Source: Bloomberg (WCAUWRLD ).

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  • 18 THE DEEPER CAUSES OF THE FINANCIAL CRISIS: MORTGAGES ALONE CANNOT EXPLAIN IT SPRING 2013

    U.S. Household Wealth

    A third way to consider the cost of the financial crisis is in terms of the loss of U.S. household wealth. This approach naturally excludes overseas effects, but it is nonetheless illustrative. U.S. household net worth experi-enced a temporary decline of more than $16 trillion and a persisting decline of more than $4 trillion.

    As shown in Exhibit 3, U.S. household net worth peaked in 2007 at roughly $67.5 trillion. It declined by more than $16 trillion over 2008 and part of 2009 to a level of about $51.3 trillion. According to the Federal Reserve, the burst housing bubble meant the loss of $7 trillion of home equity. Household net worth has since recovered to nearly $63 trillion, but that is still more than $4 trillion below its 2007 peak (Board of Governors [2012], Krueger [2012]). A good portion of the recent rise in household net worth comes from stock market gains since the fourth quarter of 2011.

    Even more striking, however, is the distribution of the decline in household net worth from 2007 to 2010 among American families. According to the latest Fed-eral Reserve Survey of Consumer Finances, the median net worth of American families declined from $126,400

    in 2007 to $77,300 in 2010, a drop of nearly 39 percent. That decline pushed the median net worth down to roughly the same level as in 1992, wiping out nearly two decades of growth (Bricker et al. [2012]).

    Significantly, the wealthiest and highest-income households were largely insulated from the decline, which fell primarily on middle- and working-class households: the shoulders least able to bear the burden. Those house-holds have experienced only a small share of the offset-ting stock-market growth since mid-2010.

    Financial Sector Write-downs

    A fourth way to gauge the impact of the crisis is by focusing on the financial sector. The IMF estimated in 2009 that banks and other financial firms would face $4.1 trillion in write-downs associated with the financial crisis (International Monetary Fund [2009]). Bloomberg reports that aggregate write-downs by financial firms around the world reached slightly more than $2 tril-lion by the end of the third quarter of 2011, and that firms had received nearly $1.6 trillion of capital infusions (Bloomberg WDCI function).

    E X H I B I T 2World GDP

    Source: World Bank (http://data.worldbank.org/indicator/NY.GDP.MKTP.CD).

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    Central Bank Balance Sheets

    A fifth way to view the cost of the financial crisis is in terms of the expansion of central bank balance sheets in the period following the onset of the crisis. Expansion of central bank balance sheets ref lects one dimension of gov-ernmental response to the crisis; with the magnitude of governmental response ref lecting the size of the problem it addresses.

    As shown in Exhibit 4, the balance sheets of the U.S. Federal Reserve, the European Central Bank, and the Bank of England each expanded markedly in the period following the crisis onset.

    At the onset of the crisis, the combined assets of the Fed, the ECB, and the BOE stood at slightly more than $3 trillion. Shortly after the crisis began, the combined assets grew by roughly $2.5 trillion to an interim peak level of roughly $5.5 trillion. After contracting strongly for a brief period in early 2009, the level of the combined assets hovered in the range of $5 trillion to $5.5 trillion through the remainder of 2009 and 2010.

    The start of 2011 marks the beginning of a second phase of balance-sheet expansion, which brought the combined assets to nearly $7.5 trillion by the start of 2012. Overall growth amounts to more than $4 trillion.

    Magnitude of U.S. Government Response

    A sixth way