In order for effective measures to be put in place to help ensure that the 2008 financial crisis will not happen again, it is important and timely to review the root causes of the crisis. With this in mind, the 10-member Financial Crisis Inquiry Commission (“FCIC”) was set up through legislation passed by the U.S. Congress and signed by President Obama in May 2009. The 18-month study included interviews on more than 700 witnesses and 19 days of public hearings in various cities and examined the roles of subprime mortgage brokers and lenders, investment banks, securitization practices, rating agencies and an insurer.

The Commission’s report provided a comprehensive review on factors leading to the 2008 crisis. Some may be independent factors (e.g., lowering of mortgage lending standards versus the development of the credit default swap market) and some may be concurrent, sequential or self reinforcing in nature (e.g., default and foreclosure from subprime mortgages in the neighbourhood having a spillover effect into surrounding regions and a further housing price drop). The interaction of multiple factors highlights the importance of reviewing policies and practices at many levels.

Ultimately, the FCIC concluded that this crisis was avoidable–the result of human actions, inactions, and misjudgments. Warnings were ignored. “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 main report: five key causes

• Failures of corporate governance and risk management at systemically important financial institutions were a key cause of this crisis. Plenty of warning signs were ignored
• A combination of excessive borrowing by households and financial institutions, risky investments, and lack of transparency in financial instruments and lending activities
• A systemic breakdown in accountability and ethics in the U.S. mortgage lending and the mortgage securitization process
• A lack of regulatory oversight of the over-the-counter derivatives market resulted in excessive leverage, which contributed significantly to this crisis. The panel highlighted the impact of the use of credit default swaps, which fuelled the expansion of mortgage securitization pipeline and creation of synthetic collateral debt obligations
• An over reliance on ratings, which failed to reflect the risk profile of mortgage related securities

Other contributing factors identified in the Report included:

• A lack of regulatory constraints on institutions, markets, and products over the past 30 years of deregulation initiatives
• Inconsistencies in the government’s response during the crisis added to the uncertainty and panic in the markets

Dissenting statements from Commission members

There were two statement reports from five Commission members who had dissenting views of the root cause of the financial crisis:

Statement Report 1: Emphasis on the credit bubble.² The origins of the financial crisis could be traced back to the credit bubble conditions in the U.S. and Europe, which began in the late 1990s. There were massive inflows of investment capital to the U.S. from countries with large capital surpluses. Easy availability of funds, exacerbated through the mortgage securitization pipeline, resulted in credit and housing bubbles, which then led up to the crisis.

Essentially, the crisis was caused by poor risk management practices at some of the large financial institutions, which resulted in a high concentration of highly correlated housing loans, insufficient capital due to high leveraging, and an over-dependence on short-term liquidity from repo and commercial paper markets.

Statement Report 2: Focus on mortgage lending.³ The crisis was created by the U.S. government’s housing policy initiatives. Through government sponsored enterprises (Fannie Mae, Freddie Mac) as well as insured banks covered by the Community Reinvestment Act, the mortgage underwriting standards were lowered by too much and thus encouraged greater subprime and high-risk lending activities than were prudent.

Potential policy implications

There are important policy implications at multiple levels. These may include:

At the regulatory level

• New regulatory oversight and disclosure responsibilities required on products, instruments and institutions involving high leverage. These may include minimum capital and collateral requirements and a regulated review process on new products
• The crisis highlighted the high level of interconnectivity between markets, and as such there is a need for closer collaboration between regulators at an international level to ensure better standardization of rules and requirements

At an industry level

The lowered mortgage-lending standard and securitization process were key root causes. Given the importance of the housing market to local and national economies, there is a need to critically review the current process and establish a sustainable framework on requirements of due diligence, documentation and remediation tasks.

In a crisis scenario

Under the defined parameters on crisis scenarios that require government intervention, policy guidelines need to be established and evaluated together with the associated costs and conditions. These may include facilities like discount windows, emergency capitalization plans, special asset relief programs.

References:

1. National balance outstanding being U.S.$26.3 trillion as of June, 2010 and U.S.$38.6 trillion as of December, 2008. Market Survey Statistics Report prepared by International Swaps & Derivatives Association, Inc.
2. Dissenting Statement of Commissioner Keith Hennessey, Commissioner Douglas Holtz-Eakin, Vice Chairman Bill Thomas
3. Peter Wallison, Arthur Burns, Fellows in Financial Policy Studies American Enterprise Institute, Jan 2011