The best explanation of the financial crisis

Russ Roberts of George Mason University, host of the wonderful weekly podcast Econtalk (and creator of the Youtube sensation Hayek vs. Keynes rap video) was unsatisfied with many of the competing explanations about why the 2008 financial crisis occurred. He was no fan of Fannie Mae and Freddie Mac or of the Community Reinvestment Act, and he acknowledges that Federal reserve policy was likely a contributing factor. But none of these stories fully explained why privately owned financial institutions acted so recklessly, to the point where they put their own existence in jeopardy. After researching the financial industry and interviewing several dozen experts on the topic, Roberts developed his own theory about why the crisis took place.

His narrative, entitled "Gambling With Other People's Money", focuses on the role of the creditor. He asks, why did creditors continue to lend to financial institutions that engaged in increasingly risky and leveraged activities? After all, creditors don’t participate in the upside of these risky bets, so why in the world did they go along with it without demanding higher and higher interest rates, or asking for more collateral, or requiring covenants that restrict the amount of risk the borrower takes on?

His answer is that over the course of the last three decades or so, with only one or two exceptions (e.g. Drexel Burnham), the government has never allowed creditors of any large financial institution to take a loss. In every case, not only were these institutions bailed out, creditors were made completely whole. They weren’t asked to take 50 cents on the dollar, or even 90 cents on the dollar. In every case, they received 100 cents on the dollar. He then asks “Did the rescue of creditors in the past increase the chances of future rescues sufficiently that creditors were careless?” He concludes yes.

He also makes an important distinction between the incentives of equity holders vs. creditors.

Equity holders don't want to get wiped out, but they are typically diversified, and they want a lot of risk-taking by some of their investments so they can make high rates of return on the upside. But because creditors don't share in the upside, they only care about the downside, and need to make sure the firm stays solvent. So, it's creditors that monitor solvency, not equity holders. It’s creditors who monitor prudence and recklessness.

For me, Roberts's narrative is the most compelling that I’ve read.

Below is a link to the paper, and a link to the podcast where he presents his story.

http://mercatus.org/publication/gambling-other-peoples-money

http://www.econtalk.org/archives/2010/05/roberts_on_the_2.html