Q 9Q 9
Forecasting in the Global Financial Crisis
The causes and consequences of the global financial crisis (GFC) are numerous and remain hotly debated. 1 8 One catalyst was clearly the collapse of the U.S. housing market in 2007-2008. The Federal Reserve played a role by overstimulating the economy during 2004-2007 when the housing asset bubble was forming. Later the Fed tightened credit conditions throughout late 2007 and early 2008 even though the Banker's Roundtable reported that loan demand had "fallen off a cliff." Congress played a role in writing legislation that encouraged home ownership by those with no real prospect of repaying a mortgage loan. Subprime mortgage loans were even granted to borrowers with no income, no job, and no assets (so-called NINJA loans). Middle-income borrowers played a role by seeking mortgages for much larger houses than they could afford. Mortgage brokers earned fat commissions facilitating these transactions which bankers approved, while bank regulators looked the other way.
In the end, the GFC was a massive failure of the capital markets that triggered what has been called the Great Contraction. U.S. GDP fell at magnitudes unseen since the -20 percent of the Great Depression of 1929-1932. In the last quarter of George W. Bush's presidency (2008Q4), real GDP fell by an astonishing -9 percent. Business confidence and private investment collapsed in 2007-2009 by -37 percent, whilst consumption declined by -2 percent. Cumulatively, four years of potential output growth approaching $1.7 trillion were lost, such that real GDP in the U.S. returned in 2011Q4 to $13.3 trillion for the first time since 2007Q4. What caused this cataclysmic event Was a lack of corporate governance or a failure of business integrity to blame
In one sense, fraudulent conveyance underlies the global financial crisis. Mortgagebacked securities that combined prime and subprime mortgages (with subprime containing too little down payment and too much default risk) were packaged and sold as highly rated A-level debt securities. Even worse, the debt buyers then stripped out the bottom tranches, repackaged these riskiest mortgage loans, and sold them worldwide also as A-rated securities. Some would argue this constitutes a fraudulent conveyance, but at a minimum, such transactions violate market integrity, for which senior executives in the banks and brokerage houses were ultimately responsible.
Market integrity is always defined relative to the expectations for fair and orderly markets of the market participants. In equity markets, for example, Aitken and Harris (2011) argue market participants expect regulators to prohibit market manipulation, insider trading, and front running conflicts of interest by broker-dealers serving as both principal and agent. 1 9 In debt markets, however, partial disclosure, rampant conflicts of interest, and some intentional manipulation and misrepresentation are expected by the market participants. Insiders regularly get on the phones and disclose unaudited financial information that is not publicly available in order to sharpen their bargaining position over a negotiated bond price. But these negotiations about the "haircut" warranted by the bond's perceived risks take place between sophisticated professionals with powerful reputation effects in repeat purchase bilateral agreements.
The contrast between stock and bond markets could hardly be greater. In stock markets, retail buyers and sellers with access to no more nor any less publicly disclosed information meet anonymous sophisticated traders in highly regulated exchange transactions. These on-exchange trades are backed by settlement clearinghouses to mitigate the counterparty risk. Posted prices are available for immediate execution by broker-agents whose duties avoid egregious conflicts of interest. And the trading prices are informationally efficient in part because the dislocations of price attributable to market manipulation are surveilled, detected, and often prevented. So, what is fair and efficient in the equity markets reflect the higher integrity expectations of equity market participants.
But just the opposite permeates the bond markets, and that is where the subprime mortgage problem arose. Highly experienced buyers of mortgage-backed securities knew that sellers were packaging mixed tranche securities with higher default rates than their A-minus ratings should convey. Normally less than 1 percent of prime mortgage borrowers default on their payments. Normally, subprime mortgage loans default in only 4 percent of all cases.
As housing prices declined 27 percent nationwide in 2007-2009 and the typical house became worth only 73 percent of its 2007 purchase price, these default percentages became 3.5 percent for prime mortgages and 13 percent for subprime mortgages. It was cheaper to walk away from a house worth less than its 80 percent mortgage, allowing the bank to foreclose, rather than to continue to make payments and hope the housing market would improve.
More foreclosures led to more distress sales, and more distress sales caused some states such as California and Florida and some municipalities such as Phoenix and Las Vegas to suffer -45 percent housing price declines. Consequently, as the GFC deepened, and the default rates worsened, everyone involved in mortgage-backed securities knew to apply deeper haircuts to the mixed tranche securities being fraudulently conveyed. The 7 percent haircut on mortgage-backed securities in November 2007 became 45 percent by November 2008. Still, that recognition did little to slow the destruction of household wealth associated with housing assets. And with negative wealth effects came a massive loss in both consumer and business confidence. The typical household became unwilling to buy consumer durables, not even a toaster, and the economy spiralled downward in something of a freefall.
Suppose senior risk managers had asked who would be the counterparties that would need to step forward to buy mortgage-backed securities when it became clear their default rates were grossly underestimated. All markets, especially financial markets, do clear with enough price adjustment. But suppose senior executives in the banks had pressed for straight answers to just how much of a haircut such fraudulently conveyed securities would require. Is it possible at least some of what has transpired could have been avoided