Analyzing the Financial Crisis of 2007 – Could it Have Been Avoided?

Although it’s been over a decade since the 2008-09 financial crisis, there are plenty of lessons to have been learned. We have enjoyed an economic recovery, to be sure, although it has been rather uneven – especially for people on the lower end of the income bracket with little to no investments or savings.

Unfortunately, those people represent nearly half of the U.S., and while there may have been easy money to be made given ultra-low interest rates and other stimulants, too many hard-working people had no means to take advantage of them.

The aftermath of the crisis produced reams of new legislation, the creation of new oversight agencies that amounted to an alphabet soup of acronyms like TARP, the FSOC and CFPB – most of which barely exist today – new committees and sub-committees, and platforms for politicians, whistle-blowers and executives to build their careers on top of, and enough books to fill a wall at a bookstore, many of which still exist.

As the COVID-19 pandemic sends the economy into a tailspin once again, the government and the Fed are looking back at the lessons learned from the last economic downturn to see how to help reduce some of the severity.

• Could the Financial Crisis in 2007 have been Avoided?
• Was the 2008 Financial Crisis Avoidable?
• Who Profited off the 2008 Financial Crisis?
• How was the Financial Crisis of 2008 Solved?
• What Caused the 2008 Recession?
• What will Cause the Next Financial Crisis?

Could the Financial Crisis in 2007 have been Avoided?

The macroeconomic forces that were unleashed in the years leading up to the financial crisis were strong. It is unlikely that a single country could have stemmed the tide. China’s participation in international trade in goods added several hundred million persons to the global workforce over a few years.

This increased the room for strong, non-inflationary global growth. China was not prepared, however, to liberalise its capital markets fully. The Chinese government was not willing to allow its currency to float freely and the exchange rate against the US dollar was managed. This disabled an important stabiliser and contributed to increasing world trade imbalances.

Long-term interest rates remained low in spite of substantial monetary policy tightening in the US between 2004 and 2006. International organisations such as the BIS, OECD, IMF and others noted on more than one occasion that growing imbalances in the world economy were a source of concern.

But economic policy decisions are the prerogative of national governments. Given the policy pursued by China, there were probably limits to what monetary policy in Western countries could in reality achieve in terms of rolling back these forces.

Increased private savings in the US and other deficit countries would probably have required monetary policy tightening sufficient to push up long-term interest rates. Alternatively, a substantial increase in public sector savings would have been necessary.

Both alternatives would probably have led to an economic policy-driven downturn. It is demanding to pursue such a policy based on the proposition that a crisis might occur in the future.

Improved financial regulation would probably have reduced the severity of the financial crisis. Regulation and insurance have similar features: in most cases an annual premium must be paid in the form of slightly lower growth.

This occurs because capital is not allowed to flow entirely freely to the highest yielding vehicles. In return, regulation can counter the build-up of financial imbalances. This reduces the probability that a negative event will trigger a severe financial crisis.

It is not optimal to be fully insured against crises because the insurance premium would be too high. But the financial crisis demonstrated that the imbalances ahead of the crisis were unsustainable and that they could have been reduced through regulatory improvements.

The reason that this did not occur may be that the risk had taken on the form of several interwoven imbalances that no single authority had the power to correct.

Banking and financial market regulation will be enhanced in Norway and abroad. The Basel Committee on Banking Supervision and the Financial Stability Board (FSB), as mandated by the G20, will soon issue recommendations for strengthening regulation of banks’ capital and liquidity management.

In the UK, the regulatory authorities have already drawn up new banking regulation. A natural consequence of the financial crisis is that increased weight is given to ensuring system-wide stability and not only the stability of individual banks.

Other important questions are whether systemically important banks should be subject to tighter regulation and how to reduce the procyclicality of bank behavior.

Recommendations from the Basel Committee and the FSB will be examined by national authorities that will subsequently adopt new regulations. In a world with a global financial market, there are limits to how far a single country go it alone.

International coordination is important for new regulations to have the intended effect. The crisis has opened a political window for tighter regulation of the financial system, but it is uncertain how long the window will remain open.

Was the 2008 Financial Crisis Avoidable?

Regulators, politicians and bankers were to blame for the 2008 US financial meltdown, a report has claimed. The US Financial Crisis Inquiry Commission, tasked with establishing the causes of the crisis, said it was “avoidable“.

Its report highlighted excessive risk-taking by banks and neglect by financial regulators. Only the six Democrat members of the 10-strong commission, set up in May 2009, endorsed the report’s findings.

“The crisis was the result of human action and inaction, not of Mother Nature or models gone haywire,” the report said.

“The captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand and manage evolving risks within a system essential to the well-being of the American public.

“Theirs was a big miss, not a stumble.”

Ethical breaches

The damning report criticised the extent of the financial deregulation overseen by the former chairman of the Federal Reserve, Alan Greenspan.

It concluded that the crisis was caused by a number of factors:

• Failures in financial regulation, including the Federal Reserve’s failure “to stem the tide of toxic mortgages”
• A breakdown in corporate governance that led to “reckless” actions and excessive risk taking by financial institutions
• Households taking on too much debt
• A lack of understanding of the financial system on the part of policymakers
• Fundamental breaches in accountability and ethics “at all levels”.

It added that “collapsing mortgage-lending standards” and the packaging-up of mortgage-related debt into investment vehicles “lit and spread the flame of contagion”.

These complex derivatives, which were traded in huge volumes by major investment banks, then “contributed significantly to the crisis” when the mortgages they were based on defaulted.

The report also highlighted the “abysmal” failures of the credit ratings agencies in recognising the risks involved in these and other products.

Blame game

Leading figures of the George W Bush and Obama administrations were not let off lightly:

• Former Federal Reserve chairman Alan Greenspan was accused of “championing” financial deregulation during the credit boom that “stripped away key safeguards”.
• Mr Greenspan was also indirectly criticised for the Fed’s overly loose monetary policy and pronouncements that “encouraged rather than inhibited the growth of mortgage debt and the housing bubble”
• The Federal Reserve Bank of New York – then under the aegis of the current Treasury Secretary, Tim Geithner – “could have clamped down on Citigroup’s excesses in the run-up to the crisis”
• The government’s handling of major financial institutions during the crisis – led by former Treasury Secretary Henry Paulson – was inconsistent and “increased uncertainty and panic in the market”
• Goldman Sachs – initially under Mr Paulson’s leadership – was singled out for its role in creating “synthetic CDOs” from 2004 that helped magnify risks by letting clients bet against the mortgage market.

However, the report did soften the blow, saying: “In making these observations, we deeply respect and appreciate the efforts made by Secretary Paulson, Chairman Bernanke, and Timothy Geithner… and so many others who labored to stabilise our financial system and our economy in the most chaotic and challenging of circumstances.”

Establishing blame was essential in preventing future crises, the report said.

“Despite the expressed view of many on Wall Street and in Washington that the crisis could not have been foreseen or avoided, there were warning signs,” said Phil Angelides, chairman of the commission.

“The greatest tragedy would be to accept the refrain that no one could have seen this coming and thus nothing could have been done.

“If we accept this notion, it will happen again.”

The commission interviewed more than 700 witnesses and held 19 days of public hearings across the US.

Dissent

All four Republicans on the commission announced several weeks in advance of the report’s publication that they would not agree with its findings.

Three of them published a separate report that insisted that blame should be attributed to Mr Greenspan’s Federal Reserve.

The fourth produced his own report focusing on the role of government in creating the housing bubble.

Republicans have pointed to the giant government-sponsored mortgage agencies (GSEs), Freddie Mac and Fannie Mae, whose subsidised lending they claim inflated the bubble.

They have also argued that legislation introduced by former Democratic President Bill Clinton had encouraged excessive and reckless lending to low income households.

In contrast, the report penned by the six Democrats on the panel said the evidence showed that the GSEs were not at the forefront of the riskiest sub-prime lending, but instead they followed the lead of Wall Street firms.

Nor was the “Community Reinvestment Act” a significant factor in subprime lending, the report said, although “community lending commitments not required by the [act] were clearly used by lending institutions for public relations purposes”.

Who Profited off the 2008 Financial Crisis?

You can’t really understand the philosophies and actions of successful investors without first getting a handle on the financial crisis. What happened in the lead up to the crash and the Great Recession that followed afterward remains stamped in the memories of many investors and companies.

The financial crisis of 2007-2008 was the worst to hit the world since the stock market crash of 1929. In 2007, the U.S. subprime mortgage market collapsed, sending shockwaves throughout the market. The effects were felt across the globe, and even caused the failure of several major banks including Lehman Brothers.

Panic ensued, with people believing they would lose more if they didn’t sell their securities. Many investors saw their portfolio values drop by as much as 30%. The sales resulted in rock-bottom prices, erasing any potential gains investors would normally have made without the crisis.

While many people were selling, there were others who saw this as a chance to increase their positions in the market at a big discount.

Warren Buffett

In October 2008, Warren Buffett published an article in The New York Times op-ed section declaring he was buying American stocks during the equity downfall brought on by the credit crisis. His derivation of buying when there is blood in the streets is to “be fearful when others are greedy, and be greedy when others are fearful.”

Buffett was especially skilled during the credit debacle. His buys included the purchase of $5 billion in perpetual preferred shares in Goldman Sachs (GS) that paid him a 10% interest rate and also included warrants to buy additional Goldman shares.

Goldman also had the option to repurchase the securities at a 10% premium. This agreement was struck between both Buffett and the bank when they struck the deal in 2008. The bank ended up buying back the shares in 2011.

Buffett did the same with General Electric (GE), buying $3 billion in perpetual preferred stock with a 10% interest rate and redeemable in three years at a 10% premium. He also purchased billions in convertible preferred shares in Swiss Re and Dow Chemical (DOW), all of which required liquidity to get them through the tumultuous credit crisis.

As a result, Buffett has made billions for himself but has also helped steer these and other American firms through an extremely difficult period.

John Paulson

Hedge fund manager John Paulson reached fame during the credit crisis for a spectacular bet against the U.S. housing market. This timely bet made his firm, Paulson & Co., an estimated $15 billion during the crisis.

He quickly switched gears in 2009 to bet on a subsequent recovery and established a multi-billion dollar position in Bank of America (BAC) as well as approximately two million shares in Goldman Sachs. He also bet big on gold at the time and invested heavily in Citigroup (C), JP Morgan Chase (JPM), and a handful of other financial institutions.

Paulson’s 2009 overall hedge fund returns were decent, but he posted huge gains in the big banks in which he invested. The fame he earned during the credit crisis also helped bring in billions in additional assets and lucrative investment management fees for both him and his firm.

Jamie Dimon

Though not a true individual investor, Jamie Dimon used fear to his advantage during the credit crisis, making huge gains for JP Morgan. At the height of the financial crisis, Dimon used the strength of his bank’s balance sheet to acquire Bear Stearns and Washington Mutual, which were two financial institutions brought to ruins by huge bets on U.S. housing.

JP Morgan acquired Bear Stearns for $10 a share, or roughly 15% of its value from early March 2008. In September of that year, it also acquired WaMu. The purchase price was also for a fraction of WaMu’s value earlier in the year.

From its lows in March 2009, shares of JP Morgan more than tripled over 10 years and have made shareholders and its CEO quite wealthy.

Ben Bernanke

Like Jamie Dimon, Ben Bernanke is not an individual investor. But as the head of the Federal Reserve (Fed), he was at the helm of what turned out to be a vital period for the Fed.

The Fed’s actions were ostensibly taken to protect both the U.S. and global financial systems from meltdown, but brave action in the face of uncertainty worked out well for the Fed and underlying taxpayers.

A 2011 article detailed that profits at the Fed came in at $82 billion in 2010. This included roughly $3.5 billion from buying the assets of Bear Stearns, AIG, $45 billion in returns on $1 trillion in mortgage-backed security (MBS) purchases, and $26 billion from holding government debt.

The Fed’s balance sheet tripled from an estimated $800 billion in 2007 to absorb a depression in the financial system but appears to have worked out nicely in terms of profits now that conditions have returned more to normal.

Carl Icahn

Carl Icahn is another legendary fund investor with a stellar track record of investing in distressed securities and assets during downturns. His expertise is in buying companies and gambling firms in particular.

In the past, he has acquired three Las Vegas gaming properties during financial hardships and sold them at a hefty profit when industry conditions improved.

To prove Icahn knows market peaks and troughs, he sold the three properties in 2007 for approximately $1.3 billion—many times his original investment.

He began negotiations again during the credit crisis and was able to secure the bankrupt Fontainebleau property in Vegas for approximately $155 million, or about 4% of the estimated cost to build the property. Icahn ended up selling the unfinished property for nearly $600 million in 2017 to two investment firms, making nearly four times his original investment.

Keeping one’s perspective during a time of crisis is a key differentiating factor for the investors noted above. Another common thread is having close connections to the reins of power, as most of these men maintained close relationships with the elected and appointed government officials and agencies that doled out trillions of dollars to the benefit of many large investors.over their careers and especially during this period.

The likes of JP Morgan and the Fed are certainly large and powerful institutions that individual investors can’t hope to copy in their own portfolios, but both offer lessons on how to take advantage of the market when it is in a panic. When more normalized conditions return, savvy investors can be left with sizable gains, and those that are able to repeat their earlier successes in subsequent downturns end up rich..........