Moody's Thoughts on the Causes of the Subprime/Credit Crisis

I recently happened upon a paper written by Moody's as part of its "Global Financial Risk Perspectives" series entitled "Archaeology of the Crisis" where the rating agency attempted to "dig a little deeper" to discover the causes of the current credit crisis. It is sort of complex and not aimed at the general investing audience, but I found it to be a pretty interesting read nonetheless. While I know that past results don't predict future performance, I do think you can learn a lot from studying market bubbles/blowups and hopefully avoid finding yourself invested in one in the future.

Moody's basic thought is that the roots of the crisis are deep and entrenched, meaning you can't just pin it on a few little things. It presents a list of seven observations that I'll discuss a little below:

1) Incentive structures in the financial markets are flawed. My read on this was that people working for banks are paid (and paid very well) based on current performance without taking the long-term impact of their decisions into account. Put more simply, people are looking to make a quick buck. Moody's goes into how this applies to traders at investment banks but I'd also note that this applies to people like mortgage originators and real estate brokers. Their commissions are paid when people buy houses. Whether or not the person defaults on a mortgage and loses his/her home down the road does not matter to the broker, so at the height of the real estate bubble, they were just stuffing anyone they could into homes they couldn't afford. The basic short-term nature of incentive structures in the financial markets inevidably introduces more risk into the system.

2) Regulators and policymakers, looking to maximize growth, don't limit banks enough to prevent financial crises. What Moody's seems to be saying here is that bank regulators such as the Federal Reserve could prevent crises by requiring banks to keep much more cash on hand to deal with problems, but then banks wouldn't be able to earn any money. Since policymakers have implicitly agreed that letting banks grow and make money is a good thing, they accept the risk of the occasional crisis.

3) "The mystifying interaction between credit risk and the economic cycle." That's how Moody's third point reads, but I will admit I had a hard time understanding their argument here until I read the next sentence "Another problem is the difficulty of measuring risk over time." I think the crux of this argument is that the people who measure risk (rating agencies, risk management departments at banks etc...) have trouble doing so because their measurements are impacted by the cyclicality of the economy and it is hard to separate structural risk from cyclical risk, because their measurements are based on the current state of the world around them, which may or may not be in the midst of an unrecognized bubble. This is a pretty arcane topic and I might not be reading it right, but let me try giving an example...

In the late 1990s before the equity market bubble burst, people were saying that risk premiums were lower, so stocks were less risky than they have been historically, and their sky-high valuations were therefore justified. These people were having trouble looking at risk from a long run perspective and were just using the results of the current market cycle which led them to believe that the world had somehow changed. It turns out the world hadn't changed, the markets were just coming to the peak of a huge uptick in the cycle. I think the London Business School paper "Global Evidence on the Equity Risk Premium" does a better job of explaining this than I could:


"Over the last decade of the twentieth century, US equity investors more than trebled their initial stake. In real terms, they achieved a total return (capital gain plus reinvested dividends) of 14.2 percent per annum. During the last five years of the 1990s, US equities achieved high returns in every year, varying from a low of twenty-one percent in 1996 to a high of thirty-six percent in 1995. Many investors became convinced that high corporate growth rates could be extrapolated into the indefinite future. With steady growth rates, equity risk appeared lower. Simultaneously, there appeared to be a decline in the premium sought by investors to compensate for exposure to equity market risk. This drove stock prices onward and upward. Surveys suggested that, in consequence, many investors expected long-run stock market returns to continue at double-digit percentage rates of return.


Then the technology bubble burst... With markets having fallen, investors started to project lower returns into the future."

4) Difficulty in tracing risk. The crux of the argument here is that all of the structures that developed in the past 10 years or so (mortgage security pools and wrappers, pools of pools, risk transfer structures etc...) were complex and opaque. The investors who purchased the risky investments like mortgage loan pools had less information than the people who created them, so it was hard for them to truly measure what kind of risks they were taking. For example, if I borrowed $200k to buy a house, the mortgage originator might sell that mortgage to an investment bank who would combine it with other mortgages into a pool, then sell off chunks of that pool to a hedge fund under various degrees of risk assumption. The hedge fund manager would never get a chance to look at my financial records, yet he owns an investment that is partially dependent on my ability to make my mortgage payments on time. The shady mortgage broker might have lied about my income on the application as a result of the incentive structures discussed in point 1 above, but the hedge fund manager would have no way of knowing that. In addition, the bank who created the security might have made some assumptions or variations to the way the loan pool was created that were buried in some 100 page prospectus that the fund manager might not have been able to discover. The way the whole process worked made it difficult to state exactly what the risks were in the security the ultimate investor owned.

5) Confusion over the definition of "liquidity." The paper gets even more arcane here, so I don't blame you if you get sick of this entry and click out to somewhere else, but to me, Moody's seems to be sort of going on the defensive here. It mentions that there is a misconception that "highly rated securities are necessarily liquid." The agency's argument is that when it gives securities a high rating based on the issuer's balance sheet, it does not necessarily mean that there will always be an orderly market for buying and selling the security, ie while the credit risk of the security might be low, the market risk might still be very high. This seems to be what happened to many of the mortgage-backed securities. As everyone decided that mortgages were toxic, it became difficult to find any buyers for the securities, so even though the majority of mortgages underlying the securities might still have been performing as expected, the securities would only sell at extremely low valuations in the market.

6) No satisfactory valuation paradigm in the credit markets. As we all know, there is often a disconnect between market prices and underlying economic values. Moody's is saying here that the models people were using to value the credit securities that came out in the past 10 years or so were inadequate, and additionally that no adequate models exist.

7) "Spurious precision" in a complex system. Basically what Moody's is saying here is that financial reporting is discrete and precise. Banks have to put a value on their liabilites and assets as of certain dates (usually quarter end for their 10-Qs and 10-Ks) yet the values of some assets and liabilites cannot be precisely estimated, as pointed out in point 6. This leads to huge writedowns and further panic in the financial system.

I am sure our current market conditions and the ultimate fallout (the extent of which we don't know yet) will be well studied in the future but I think the above points do get at some of the main causes of the current crisis in the financial markets.

Could The Great Depression Have Been Averted?

I had the opportunity to study the Great Depression while I was in grad school, and I put the meat and potatoes of a paper I did on the topic here in case you're interested in my take. I didn't do a fantastic job of keeping my citations in order, but I'm sure if you take the time to do it, you can fairly easily double-check the facts below.

The depression interests me. Our generation has never seen anything like this. The closest we got were the few years after the internet bubble burst circa 2000. That, coupled with the 2001 terrorist attacks, didn't even come close to the kind of broad scale havoc the depression wreaked on the people who lived through it.

I know we have our fail-safes in place. We have the triggers that close the markets down if a panic sets in, we have a more activist Federal Reserve, we have the FDIC etc... but has it all ever really been put to the test? Hopefully nothing like that ever happens in our time.

Anyway, this paper revisits the Fed's role around the time of the Great Depression and at the end I have the audacity to look in the rear view mirror and say if the Fed had acted differently, things might not have turned out as bad as they did.


The Goals of the Federal Reserve in the 1920s

The Federal Reserve System (also referred to as the “Fed”) was formed in 1914 to serve as the United States’ central bank. Its primary goal was to give the US government some measure of control over the money supply in order to dampen the impact of financial crises on the economy. Before the Fed was created, the government had little to no control over the money supply, which was tied to the gold standard.

In the 1920s and early 1930s, the Fed’s leaders said their primary purpose was to serve as “a system of productive credit.” This meant it existed to lend money to member banks for “productive” purposes involving only agricultural, industrial or commercial pursuits and not for what it called “speculative” or investment purposes. In this way, the Fed operated in what was for the most part a passive manner. In theory it could affect the money supply by setting interest rates to encourage or discourage bank borrowing, but it was up to the discretion of the banks whether or not they would borrow money from the Fed. The Fed shied away from use of its more active tool- open market activities, for reasons we will later discuss.

Another main goal of the Federal Reserve during this time period was to maintain the gold standard, keeping gold reserves on hand to collateralize the US dollar. By law, the Fed was required to maintain reserves equal to the value of at least 40% of the outstanding reserve notes, as well as 30% of deposits held at the Fed.

Reasons for Pursuing These Goals

The reason the Fed would have pursued these goals was the prevailing economic wisdom of the time. Most of the industrialized world had been on the gold standard for 200 years[1], and it was seen as the proper way to run an economy. With banks having experienced periodic liquidity problems in the past, the Fed wanted to be sure it could serve as a “lender of last resort” should a panic create the need for banks to return money to depositors beyond the level of their reserves. Monetary theory as we know it today was undeveloped during the period.

What the Fed Could Have Been Doing

An alternative goal the Fed might have pursued would have been to work at increasing aggregate demand and keeping the economy at full employment with low inflation. These are the Fed’s goals today, and would have meant taking a more active role to stimulate or restrain the economy via the money supply. At times, this would have meant more aggressively employing open market operations.

In the 20s, however, the Fed was generally wary of open market purchases, which it believed would serve to fuel “inflationary speculation, not increasing output of goods and services.” Keynes was only first beginning to publish his theories in the early 20s, and the idea of such active tinkering with the economy by a central bank had not been embraced. Even the most liberal Fed board members were generally opposed to open market purchases. As the case stated, they saw such purchases as a kind of “shotgun approach” and believed it would take more careful aim to respond to the problems they faced.

Factors responsible for the collapse of the money supply between 1929 and 1933

A number of factors were responsible for the collapse of the money supply during this period, when M1 fell 25%, from $26 billion to $19.5 billion.[2] These included:

An “internal drain” from bank deposits to currency. Following the stock market collapse in 1929 and the ensuing lack of faith in the financial system, there was a wave of bank failures in the fall of 1930, noticeably among smaller regional banks that had loaned to now-insolvent farmers. With the realization that bank deposits could disappear if banks failed, there was an increasing public desire to hold currency, and a rush to empty bank accounts. Since banks did not hold enough money to reimburse every depositor, these bank runs led to further bank failures. The resulting drop in deposits served as an “internal drain” on the money supply. With fewer deposits on reserve, the banks could loan out less money, due to their required reserve ratios.

An “external drain” of foreigners’ dollar deposits and gold from the US. Following Great Britain’s departure from the gold standard on October 21, 1931, worldwide attention turned to the United States. Worried that a financial crisis could hurt dollar investments in the United States and possibly bring about the demise of the gold standard there too, foreigners began to convert American bank deposits into gold.

As foreigners took money out of American bank accounts and redeemed dollars for gold, Fed gold reserves began to dwindle, falling over 15% between September 31 and October 28 of 1931. If outflows continued, the Fed would not be able to maintain the 40% gold reserve level required to support the value of its outstanding notes. In order to stem the gold outflow, and in response to increasing pressure from France in particular, the Fed raised bill buying and discount rates in October of 1931. The move did slow the outflow, but as is typically the case, higher interest rates also served to contract the money supply. This added further to the collapse.

The Fed’s avoidance of open market purchases. Though the lack of reliance on open market purchases was not in itself a cause of the declining money supply, it was a tool that could have been used to prevent the collapse. As described on page 6 of the HBS case, New York Fed Governor George S. Harrison “argued for more open market purchases” in 1930, but he was overruled by the heads of most of the other Fed banks, who felt that low bill buying rates (which had been reduced to 2% in 1930 and 1.5% in 1931) made credit easy to obtain, making further purchases undesirable.

Despite easy credit, borrowing from the Fed shrank by 83% between July 1929 and September 1930, highlighting the fact that interest rate adjustments were a passive tool. Lower rates as they might, the Fed could not force banks to borrow, and banks’ unwillingness to borrow served to keep the money supply from growing. The only way to “force” money into the system would have been through open market purchases, over which the Fed had complete discretion.

Did Monetary Forces Cause the Great Depression?

Due to the complexity of the US economic system, I would be hesitant to pin the great depression on monetary forces alone. However, I think that monetary forces played a large role in causing the depression, and greatly contributed to its length and severity.

The beginning of the great depression was associated with a deflationary trend that began in 1929. This deflation can be explained by the contraction in the money supply that began in 1929, due to reasons previously discussed. Deflation had a negative effect on the US economy by reducing consumer demand. Noticing that prices were falling, consumers delayed current purchases. This dropoff in demand led businesses to produce less and lay off workers, causing unemployment to jump from 3.2% in 1929 to 25.2% in 1933.

Bank failures were another large contributing factor to in the great depression, and it seems that the vicious circle of runs on bank deposits causing banks to fail and fueling further runs on banks could have been averted had the money supply been adequate to cover Americans’ desire to hold currency. When the first groups rushed to hold currency instead of savings deposits, the money supply failed them. Losing savings, or hearing about others losing savings, served to darken the spirits of consumers in a manner that economic statistics cannot adequately measure, compounding the other factors that weakened the economy at the time.

The contracting money supply also served to reduce income, and according to Keynsian theory, income determines consumption. This dropoff in consumption, combined with decreasing business output caused GDP to drop from $822.2 billion to $602.3 billion during the period.

It would take until 1936 for GDP to return to the $820 billion levels seen in 1929. I would argue that, had the Fed intervened in a more effective manner to prevent the collapse of the money supply over that critical 1929-1932 period, the impact on the economy would have been mitigated, and there is a possibility that “The Great Depression” would now be known only as “The Depression.”

[1] Siegel, Jeremy. “Stocks For the Long Run.” McGraw-Hill, 2002. p. 186.
[2] Godon, Robert. “Macroeconomics.” Pearson Education, 2003. p. A2.