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Six Characters in Search of a Crisis

The world continues to be perplexed about which individuals and entities were responsible for the financial crisis and why it took on such gigantic proportions. This article discusses the role of six suspects: Alan Greenspan, Bill Clinton, George Bush, the banks, the system of fair value accounting and the credit rating agencies.

Sgherri 2007)

ow short-term rates could have led to the carry trade whereby money went into bonds, stocks, real estate, emerging markets, and commodities – anywhere that it might earn a higher return than the very low rates that were on offer in the US and Japan (Frankel 2006).1 The trouble with the perception of rising housing price is that in the US it created a selffulfilling prophecy that prices would continue to go up and up and cannot come down ever (Chart 1, p 33).

he monetary policy of low interest rates was initiated in response to the collapse of the new economy “bubble” and then the post-9/11 recession of 2001. An enormous amount of liquidity was pumped into the global monetary system during 2001-05 with the short-term interest rates reduced to 1% (their lowest level in 50 years). In fact,

Lombarda and

Irrespective of the fact of whether the Fed was ill-equipped or whether it was lax, Greenspan remains a strong character in search of the crisis.

0 – Case Schiller composite home price indices Fed funds rate
– 2 – 2 – 2 – 1 – 1 – 1 – 1 – 1 Clinton Era Bush Era S&P/Case Schiller composite home price indices OFHEO seasonally adjusted house price

ments deviate from their commercial considerations? After Clinton came to power in 1993, it has been alleged that he extensively rewrote the rules of Fannie and Freddie and pushed the social case for wider homeowning. With incentives for aggressive loan disbursements, banks poured billions of dollars of loans into poor households often with incomplete In what way did the housing loan disburse-


The involvement of Clinton is best captured in t


The scenario did not change much during the eight years of the George Bush regime.

The economy was indeed in a Goldilocks scenario; it is best captured in what President George Bush said on

At this point it may be useful to digress from the trends in housing price in the US. It has been conclusively shown that the sharp rise in housing prices in the US cannot be explained in terms of a hike in construction costs or population pressure (Schiller 2008). While low interest rates and affirmative government action could have boosted house prices to some extent, from today’s vantage point the presence of the bubble in the housing market seems obvious. Between 2001 and 2005, US homeowners enjoyed an average increase of more than 54% in the value of their houses, as measured by the Office of Federal Housing Enterprise Oversight. Did the Bush administration recognise these facts? The answer is an emphatic, “No”. Consider the following three instances.

First, the fact sheet from the White House press release of 9 August 2005 mentioned that, “Sales of both new and existing homes reached all-time highs, as the strong housing market continues to be powered by strong job growth and low interest rates. New home sales rose 6.1% from the first quarter, while sales of existing homes rose 5.6%” (


Second, the then Treasury Secretary John Snow in commenting on housing starts in the US economy, went on to say as late as on 20 December 2005, “We can see now that 2005 will be a record year for housing starts, and with permits to build continuing to exceed starts, it appears as if residential construction will remain robust

– and that’s great news for American

families” ( .

Finally, Greenspan as late as in 2005 observed that: “ …(W)e are facing not a bubble but a froth – lots of small local bubbles that never grew to a scale that could threaten the health of the overall economy” (Greenspan 2007: 231).

All these are pointers to the fact that Bush administration missed the presence of a bubble in the US housing market and as long as house prices were rising they took immense credit for the Goldilocks economy.

How then did the Bush administration see the brewing of the subprime crisis? It is only on 11 February 2008 that the Economic Report of the President noted:

Thus, the complex adjustable rate mortgage, coupled with a low degree of financial literacy of an average American subprime borrower, aided by the liberal government housing policy and low interest rates provided a fertile ground for the subprime crisis which was waiting to happen.

At this juncture one can take pause and think back as to why a bad loan taken by a lower middle class family in mid-west America should lead to an unprecedented global financial crisis. Is the world so flat? After all, we know that if a borrower is unable to replay a loan taken from a bank, then the bank has to provide for this bad debt. If the bank does not provide for this bad loan, it is the duty of the bank inspector to catch this failure. Were both banks and bank inspectors lax? This apart, there are two more questions: First, how come all the loans taken from a particular bank go bust? Second, how do all the loans taken from all the banks go bust? The sins of a bad loan got translated into a global misfortune through three other dramatic personae, viz,

  • (a) the
  • and the investment bankers in search of a structured financial product;
  • (b) the accountant; and (c) the credit rater. We will now turn to each of them.
  • he GSEs can either sell the mortgage-backed securities to other investors or retain the securities for themselves. In the 1990s, Freddie gradually shifted from a strategy of selling most of its securities to a strategy of retaining most of its securities. Fannie has always predominantly held its securities in its portfolio. Whether it retains or sells the security, the GSE bears the default risk of the mortgages, which is the source of the recent crisis (King 2008).

    Although both Fannie and Freddie are private companies, as “government-sponsored enterprises” established by federal law, they receive special privileges. The most important of these privileges is the notion of an implicit guarantee so that the investors tend to believe that if these GSEs are threatened with failure, the federal government will come to their rescue. As Krugman (2008) has noted: “

    Although fair values have played a role in US Generally Accepted Accounting Principles (GAAP) for more than 50 years, in September 2006, the Financial Accounting Standards Board issued an important new standard, Statement of Financial A ccounting Standards No 157, Fair Value Measurements (FAS 157) in this regard. FAS 157 defines fair value as “…. The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”. The FAS 157 actually p


    918.87 2,191.57 3,779.40 8,422.26 17,096.14 34,422.80

    It took nearly a decade for the US administration to realise that there was something inherently wrong with these products. Appearing before the House Committee on Oversight and Government Reform, Alan Greenspan on 23 October 2008, said, “I made a mistake in presuming that the self-interests of organisations, specifically banks and others were such that they were best capable of protecting their own shareholders and their equity in the firms.”

    Since the market for a number of structured products became non-existent during the period of the financial meltdown, financial institutions suffered huge losses on account of valuation; for example,

    The problems in valuing various derivative instruments during the financial market turmoil led to the allegations that fair value accounting exacerbated the meltdown in the US banking system and forced investment and commercial banks to write down well over $100 billion in assets.

    In the original

    Mason, Joseph R (2008): “A National Homeownership Strategy for the New Millennium”, Market Commentary, available at .

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