2008 Financial Crisis

The financial crisis of 2007 and 2008 began in American housing, spread through securitised mortgage debt into the balance sheets of banks on both sides of the Atlantic, and culminated in the bankruptcy of Lehman Brothers on 15 September 2008. Credit markets seized, world trade contracted at rates not seen since the 1930s, and governments committed trillions of dollars to keeping banks open.

Conservatives dispute the standard account that deregulation caused the collapse. The alternative reading holds that the crisis grew out of government intervention in credit markets: a central bank that held interest rates below any reasonable rule for years, housing policy that pushed lenders toward borrowers who could not repay, and a long record of rescues that taught large institutions their downside was socialised. On this reading the state was not the absent referee but a participant with the largest position on the table.¹

Key Takeaways

• BNP Paribas froze three funds on 9 August 2007, the first clear signal that no one could price mortgage securities.
• Bear Stearns was sold to JPMorgan Chase in March 2008 with Federal Reserve support; Fannie Mae and Freddie Mac entered conservatorship on 7 September 2008.
• Lehman Brothers filed for Chapter 11 on 15 September 2008. AIG received an 85 billion dollar credit line from the Federal Reserve the following day.
• Congress passed the Troubled Asset Relief Program, authorising 700 billion dollars, on 3 October 2008; the Federal Reserve cut its target rate to between zero and 0.25 per cent in December.
• The Financial Crisis Inquiry Commission split three ways in January 2011, and its dissents remain the clearest statement of the conservative diagnosis.

History And Context

The build-up ran for roughly a decade. After the dot-com collapse and the attacks of September 2001, the Federal Reserve cut the federal funds rate to 1 per cent by June 2003 and held it there until June 2004, a stance John Taylor calculated as far looser than his own rule would have prescribed and one he identified as the principal cause of the housing boom.² Cheap money met a mortgage market that had learned to sell its loans rather than hold them, which severed the link between the person approving a loan and the person bearing the loss.

Congressional housing policy pushed in the same direction. The affordable housing goals imposed on Fannie Mae and Freddie Mac from 1992 were raised repeatedly, reaching 56 per cent of purchases by 2008, and the two enterprises accumulated large exposure to loans that did not meet traditional underwriting standards. Their implicit federal guarantee let them borrow more cheaply than any private competitor, and their capital requirements were a fraction of a commercial bank’s.

Ratings agencies compounded the problem. Regulation had written the judgements of a handful of designated agencies directly into capital rules, so an AAA stamp was not merely an opinion but a licence to hold an asset against thin capital. The agencies were paid by the issuers whose paper they rated.

House prices peaked in mid-2006 and fell. Subprime originators failed through 2007. When Lehman was allowed to go under in September 2008 after Bear Stearns had been rescued, counterparties concluded that no rule governed who would be saved, and short-term funding markets stopped. The Reserve Primary Fund broke the buck the next day, and commercial paper froze for firms with no connection to housing at all.

The Conservative Position

Conservatives read the episode as a case study in moral hazard. Institutions rescued in 1984 at Continental Illinois, in 1998 at Long-Term Capital Management and in early 2008 at Bear Stearns had grounds to expect help again, and priced their risk accordingly. Profits stayed private; losses did not. Once that expectation exists, no amount of supervisory rule-writing restores prudence, because prudence is a response to consequences.

The second theme is the pretence of knowledge. Capital rules, stress models and value-at-risk calculations rested on the assumption that regulators could measure risks that the institutions taking them could not measure. Conservatives regard that assumption as the recurring error of technocratic government, and the crisis as its most expensive demonstration.

The third is the political economy of housing. Homeownership was a bipartisan objective pursued through credit rather than through savings, because credit subsidies do not appear in the budget. Raghuram Rajan argued that easy housing finance functioned as a substitute for addressing stagnant incomes, a way of letting people consume what politics had not delivered.³ Conservatives add that when a government decides a particular asset should rise in price forever, it has created the conditions for the bubble it will later blame on speculators.

On the response, conservative opinion divides. Most accept that some intervention was required once the payment system was at risk, and object instead to the terms: creditors made whole, executives retained, and no resolution regime that would let a large firm fail without taking the economy with it.

Differing Positions

The majority of the Financial Crisis Inquiry Commission reached the opposite conclusion. It found the crisis avoidable and blamed failures of financial regulation and supervision, excessive leverage at private firms, and a breakdown in corporate governance, pointing to the repeal of Glass-Steagall in 1999, the Commodity Futures Modernization Act of 2000 which exempted over-the-counter derivatives from regulation, and the Securities and Exchange Commission’s 2004 change to net capital rules for the largest investment banks.⁴

On the housing question specifically, the majority held that Fannie Mae and Freddie Mac followed the private market into risky lending rather than leading it, noting that private-label securitisation, not the government enterprises, originated the worst subprime vintages of 2005 and 2006 and that the Community Reinvestment Act did not cover the independent mortgage companies that made most of those loans. Peter Wallison’s dissent contested precisely that point, arguing that federal housing policy had put roughly 27 million non-traditional mortgages into the system by 2008.

A third account, associated with Ben Bernanke and with Hyman Minsky’s earlier work, treats the specific policy errors as secondary to a global savings glut and to the tendency of long stability to breed the leverage that ends it.

References

1. Peter J. Wallison, dissenting statement, in The Financial Crisis Inquiry Report (US Government Printing Office, 2011).
2. John B. Taylor, Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis (Hoover Institution Press, 2009).
3. Raghuram G. Rajan, Fault Lines: How Hidden Fractures Still Threaten the World Economy (Princeton University Press, 2010).
4. Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report (US Government Printing Office, 2011).