Dish Check Update: Who Caused The Financial Crisis?


A reader manages to compress the complicated truth into a compact email:

high-risk loans –> mortgage-backed securities –> collateralized debt obligations –> credit default swaps –> synthetic collateralized debt obligations

This is the supply chain that inflated the bubble and eventually caused the collapse. Because many different people and organizations were involved, you can make a credible-sounding case that any of them was responsible – from AIG to Lehman Brothers to Standard & Poors to Countrywide to the immigrant fruit-picker with the liar's loan.  Of course, we hear all of these various players blamed at various times by various people.  And of course, in precipitating the collapse each did play a critical role – probably a necessary role in its unfolding as it did.  But that doesn't mean that each is equally responsible, any more than your employer is responsible for your car crash – if he hadn't decided to rent that specific office space, you wouldn't have been in that exact spot on the highway at the exact time the guy next to you swerved while trying to text his mistress.

Then who is responsible?  I think there are a few factors to consider:  1) where was the real scale and risk created in the chain?  2) where was the real impetus – who was creating/accelerating the "pull?"  3) who should have known better?  I think the answers to these questions point squarely at Wall Street and AIG, and to a lesser extent the ratings agencies.  Sub-prime lenders were dirtbag cheats, and many high-risk borrowers were foolishly irresponsible, but that doesn't make them responsible for the collapse, just among those morally at fault – a subtle yet important distinction.

1)  There were a lot of high risk loans issued during the 2000s, but Wall Street took something big, made it enormous, and connected it into the fabric of our economy.  

Wall Street firms were regularly leveraged 30:1 or more making big bets on their MBS/CDO factories, putting at risk their legitimate function of supplying credit to Main Street (the legitimate part being a miniscule fraction of their overall profits).  Furthermore, vehicles like synthetic CDOs allowed the scale of the bubble to be increased by orders of magnitude – the equivalent of having 50 homes in a fire-prone neighborhood, but with 100 insurance policies on each and a lively market of bets on which will burn down first.  If this were just a sub-prime housing crash, it would have hurt (think dot-com crash), but it wouldn't have brought the global financial system to its knees.  That required Wall Street and AIG, with the ratings agencies helping along the way (by convincing institutional investors that all was safe).

2)  It's a little counter-intuitive, but Michael Lewis describes it well in The Big Short.  This wasn't a bubble driven by the front of the supply chain – borrowers and lenders – but instead pulled from Wall Street.  If Wall Street weren't buying all these bad loans, the bubble would have been pretty short-lived and small.  It was the ability to buy a pile of shit and sell it as gold that drove the entire chain – Wall Street alchemy enabled by the ratings agencies.  You could buy sub-prime MBSs low and sell them high as CDOs to unsuspecting investors (and even better, insure them for cheap with AIG).  This created an insatiable appetite for trash loans, which created a frenzy by sub-prime lenders to do anything and everything to feed them, including ever-lower standards and outright fraud.  The demand for loans also helped drive up the housing market, which reinforced the cycle and hid the risks in the alchemy.  You could argue that the ratings agencies were most at fault here, but a closer look reveals that they were full of second-rate analysts (always have been) duped by first-rate quants at the Wall Street firms, and pressured by those firms to stay in line or else lose their business (credit to Lewis here again).

3)  Some have argued that borrowers should have known better than to sign up for loans they couldn't afford.  I agree, but this argument should be strongly tempered by the realization that each time someone risked their home and credit rating there was a lender putting up hundreds of thousands of dollars on the same deal.  Is it really fair to expect that the poor schlub should have known better than the broker, the underwriter, and the institutional investor?  And when the quants and sales desks at the big Wall Street firms created and hyped these financial vehicles of mass destruction, duping ratings agencies and institutional investors alike, is it really fair to say that they were just making markets and all the counter-parties should have known better?  In this respect, only AIG rises to the same level of blame as the Wall Street "wizards" – not just for issuing insurance policies on assets they clearly didn't understand, but for issuing so many for so much.  At a certain point, you've got to take a closer look.

(Photo: A police officer guards the Wall Street bull as demonstrators associated with the 'Occupy Wall Street' movement face off with police in the streets of the financial district after the deadline for their removal from Zuccotti Park was postponed on October 14, 2011. By Spencer Platt/Getty Images)