Fault Lines

Global Thinker No. 26 Raghuram Rajan's look at the fissures that brought about the global financial crisis -- and which are still at work today.

Although I worried about banker incentives and regulatory motives at the time of the financial crisis, and although many more commentators and regulators have since come around to my point of view, I have come to believe that these issues are just the tip of the iceberg. The true sources of the crisis we have experienced are not only more widespread but also more hidden. We should resist the temptation to round up the most proximate suspects and pin the blame only on them. Greedy bankers can be regulated; lax government officials can be replaced. This is a convenient focus, because the villains are easily identified and measures can be taken against malfeasance and neglect. What's more, it absolves the rest of us of our responsibility for precipitating the crisis. But this is too facile a response.

We should also resist the view that this is just another crisis, similar to every financial crisis before it, with real estate and foreign capital flows at its center. Although there are broad similarities in the things that go wrong in every financial crisis, this one centered on what many would agree is the most sophisticated financial system in the world. What happened to the usual regulatory checks and balances? What happened to the discipline imposed by markets? What happened to the private instinct for self-preservation? Is the free-enterprise system fundamentally broken? These questions would not arise if this were "just another" crisis in a developing country. And given the cost of this crisis, we cannot afford facile or wrong answers.

Although I believe that the basic ideas of the free-enterprise system are sound, the fault lines that precipitated the crisis are indeed systemic. They stem from more than just specific personalities or institutions. A much wider cast of characters share responsibility for the crisis: it includes domestic politicians, foreign governments, economists like me, and people like you. Furthermore, what enveloped all of us was not some sort of collective hysteria or mania. Somewhat frighteningly, each one of us did what was sensible given the incentives we faced. Despite mounting evidence that things were going wrong, all of us clung to the hope that things would work out fine, for our interests lay in that outcome. Collectively, however, our actions took the world's economy to the brink of disaster, and they could do so again unless we recognize what went wrong and take the steps needed to correct it.

There are deep fault lines in the global economy, fault lines that have developed because in an integrated economy and in an integrated world, what is best for the individual actor or institutions is not always best for the system. Responsibility for some of the more serious fault lines lies not in economics but in politics. Unfortunately, we did not know where all these fault lines ran until the crisis exposed them. We now know better, but the danger is that we will continue to ignore them. Politicians today vow, "Never again!" But they will naturally focus only on dealing with a few scapegoats, not just because the system is harder to change, but also because if politicians traced the fault lines, they would find a few running through themselves. Action will become particularly difficult if a more rapid recovery reinforces the incentives to settle for the status quo. This book is, therefore, an attempt to heed the warnings from this crisis, to develop a better understanding of what went wrong, and then to outline the hard policy choices that will tackle the true causes of the crisis and avert future ones.

Let us start with what are widely believed to be the roots of this crisis, which is, in part, a child of past crises. In the late 1990s, a number of developing countries (in the interests of brevity, I use the term developing for countries that have relatively low per capita incomes and industrial for those that have high per capita incomes), which used to go on periodic spending binges fueled by foreign borrowing, decided to go cold turkey and save instead of spend. Japan, the second largest economy in the world, was also in a deepening slump. Someone else in the world had to consume or invest more to prevent the world economy from slowing down substantially. The good news for any country willing to spend more was that the now-plentiful surplus savings of the developing countries and Japan, soon to be augmented by the surpluses of Germany and the oil-rich countries, would be available to fund that spending.

In the late 1990s, that someone else was corporations in industrial countries that were on an investment spree, especially in the areas of information technology and communications. Unfortunately, this boom in investment, now called the dot-com bubble, was followed by a bust in early 2000, during which these corporations scaled back dramatically on investment.

As the U.S. economy slowed, the Federal Reserve went into overdrive, cutting interest rates sharply. By doing so, it sought to energize activity in sectors of the economy that are interest sensitive. Typically, such a move boosts corporate investment, but corporations had invested too much already during the dot-com boom and had little incentive to do more. Instead, the low interest rates prompted U.S. consumers to buy houses, which in turn raised house prices and led to a surge in housing investment. A significant portion of the additional demand came from segments of the population with low credit ratings or impaired credit histories -- the so called subprime and Alt-A segments -- who now obtained access to credit that had hitherto been denied to them. Moreover, rising house prices gave subprime borrowers the ability to keep refinancing the low interest rate mortgages (thus avoiding default) even as they withdrew the home equity they had built up to buy more cars and TV sets. For many, the need to repay loans seemed distant and remote.

The flood of money lapping at the doors of borrowers originated, in part, from investors far away who had earned it by exporting to the United States and feeding the national consumption habit. But how did a dentist in Stuttgart, Germany, make mortgage loans to subprime borrowers in Las Vegas, Nevada? The German dentist would not be able to lend directly, because she would incur extremely high costs in investigating the Vegas borrower's creditworthiness, making the loan conform to all local legal requirements, collecting payments, and intervening in case of default. Moreover any individual subprime homebuyer would have a high propensity to default, certainly higher than the level of risk with which a conservative private investor would be comfortable.

This is where the sophisticated U.S. financial sector stepped in. Securitization dealt with many of these concerns. If the mortgage was packaged together with mortgages from other areas, diversification would reduce the risk. Furthermore, the riskiest claims against the package could be sold to those who had the capacity to evaluate them and had an appetite for the risk, while the safest, AAA-rated portions could be sold directly to the foreign dentist or her bank.

The U.S. financial sector thus bridged the gap between an overconsuming and overstimulated United States and an underconsuming, understimulated rest of the world. But this entire edifice rested on the housing market. New housing construction and existing housing sales provided jobs in construction, real estate brokerage, and finance, while rising house prices provided the home equity to refinance old loans and finance new consumption. Foreign countries could emerge from their slump by exporting to the seemingly insatiable U.S. consumer, while also lending the United States the money to pay for these imports. The world was in a sweet but unsustainable spot.

The gravy train eventually came to a halt after the Federal Reserve raised interest rates and halted the house price rise that had underpinned the frenzied lending. Subprime mortgage-backed securities turned out to be backed by much riskier mortgages than previously advertised, and their value plummeted. The seemingly smart bankers turned out to have substantial portions of these highly rated but low-quality securities on their balance sheets, even though they must have known what they contained. And they had financed these holdings with enormous amounts of short-term debt. The result was that short-term creditors panicked and refused to refinance the banks when their debts came due. Some of the banks failed; others were bailed out even as the whole system tottered on the brink of collapse. Economies across the world went into a deep slump from which they are recovering slowly.

This narrative leaves many questions unanswered. Why was the flood of money that came in from outside the United States used for financing subprime credit? Why was the United States, unlike other economies like Germany and Japan, unable to export its way out of the 2001 recession? Why are poorer developing countries like China financing the unsustainable consumption of rich countries like the United States? Why did the Federal Reserve keep rates so low for so long? Why did financial firms make loans to people who had no income, no jobs, and no assets -- a practice so ubiquitous that it attracted its own acronym, NINJA loans? Why did the banks -- the sausage makers, so to speak -- hold so many of the sausages for their own consumption when they knew what went into them?

I attempt to address all these questions in this book. Let me start by saying that I do not have a single explanation for the crisis, and so no single silver bullet to prevent a future one. Any single explanation would be too simplistic. I use the metaphor of fault lines. In geology, fault lines are breaks in the Earth's surface where tectonic plates come in contact or collide. Enormous stresses build up around these fault lines. I describe the fault lines that have emerged in the global economy and explain how these fault lines affect the financial sector.

One set of fault lines stems from domestic political stresses, especially in the United States. Almost every financial crisis has political roots, which no doubt differ in each case but are political nevertheless, for strong political forces are needed to overcome the checks and balances that most industrial countries have established to contain financial exuberance. The second set of fault lines emanates from trade imbalances between countries stemming from prior patterns of growth. The final set of fault lines develops when different types of financial systems come into contact to finance the trade imbalances: specifically, when the transparent, contractually based, arm's-length financial systems in countries like the United States and the United Kingdom finance, or are financed by, less transparent financial systems in much of the rest of the world. Because different financial systems work on different principles and involve different forms of government intervention, they tend to distort each other's functioning whenever they come into close contact. All these fault lines affect financial-sector behavior and are central to our understanding of the recent crisis.


Looking Back on Too Big to Fail

From the new afterword to Andrew Ross Sorkin's classic tale of the financial crisis, recommended by several FP Global Thinkers: Have we learned anything from our failures?

Two years after the greatest financial crisis of modern times, are we any closer to solving the Too Big to Fail conundrum?

Yes -- and no.

The new reform legislation that is expected to be passed goes a long way toward fixing the way certain parts of Wall Street are regulated. The government is planning to create a Consumer Financial Protection Agency to be a watchdog over how mortgages and other products are sold by banks. It is also putting together a systemic risk council made up of various agencies to better share information in hopes of being able to spot a potential crisis before it turns into a real one. In addition, the legislation will likely push derivative trading at big banks into better-capitalized subsidiaries. And the government will finally be given resolution authority so it can wind down a big investment bank or insurance company -- think Lehman and AIG -- without the risks associated with a bankruptcy that could cascade through the system.

But the legislation still doesn't go far enough. It has no provisions to deal with Fannie Mae and Freddie Mac, which have cost taxpayers some $130 billion. Derivatives will still be allowed to live, at least partially, in an opaque world. And big banks will still be big banks and they are still as interconnected as ever.

Early in the process Senator Bernie Sanders of Vermont responded to the legislation's shortcomings by introducing the "Too Big to Fail, Too Big to Exist Act," giving the government power to break up systemically important institutions. Senators Maria Cantwell of Washington and John McCain of Arizona, meanwhile, introduced a bill to reinstate Glass-Steagall. Neither proposal gained much enthusiasm, in part, because of arguments made by the industry that it would make the United States less competitive in the global marketplace.

"The fact is that some businesses require size in order to make necessary investments, take extraordinary risks, and provide vital support globally," Jamie Dimon of JPMorgan Chase said. "America's largest companies operate around the world and employ millions. This includes companies that can make huge investments -- as much as $10 billion to $20 billion a year -- and compete in as many as fifty to one hundred countries to assure America's long-term success."

Perhaps the most disquieting development that has taken place during the past year hasn't been on Wall Street or in Washington, but global. No longer is the phrase "too big to fail" being associated with banks alone. It is now being used to describe municipalities and countries that, like many home borrowers, have become overleveraged. Much recent concern has focused on Greece, but Spain, Italy, Portugal, and Ireland are all considered vulnerable. In the United States, worries persist about whether the state of California will ultimately meet its day of reckoning.


"We cannot control ourselves. You have to step in and control The Street."

Morgan Stanley Chairman John Mack, standing next to his wife, Christie, made this remarkably candid and poignant comment about the need for regulation in the fall of 2009, just a month after Too Big to Fail was originally published. Mack had been sitting in the audience of a panel on the financial crisis on which I was appearing when he surprised the group by offering a viewpoint that was contrary to that of most of his peers, who had been lobbying against any serious reform.

Mack offered an anecdote about why Wall Street's culture -- and perhaps our global culture of risk taking -- would make self-policing nearly impossible.

At the height of the economic boom, he recounted, he had turned down an opportunity to make a highly leveraged loan, which would have likely included enormous fees, out of fear that it would later blow up.

"I missed a piece of business," he acknowledged. "I can live with that, but as soon as I hung up the phone someone else put up ten times leverage."

It is the ultimate truism: In the race for profits on Wall Street and elsewhere -- and perhaps more important, as a matter of personal pride -- someone is always willing to stick his neck out just a little farther than the next guy.

While that sort of heedless risk-taking has led to lucrative returns for many financiers in recent decades, the vulnerabilities in the financial system that have been exposed by the crisis must at some point lead to an accounting -- not only of the practices that have become common on Wall Street but of the principles that underlie them. As Harvard's Elizabeth Warren, chair of the Congressional Oversight Panel, has observed, "This generation of Wall Street CEOs could be the ones to forfeit America's trust. When the history of the Great Recession is written, they can be singled out as the bonus babies who were so shortsighted that they put the economy at risk and contributed to the destruction of their own companies. Or they can acknowledge how Americans' trust has been lost and take the first steps to earn it back."