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Foreigners Caused America’s Financial Crisis? A Closer Look
In his State of the Union address, President Obama reiterated his ambitious agenda to improve the economy and enact sweeping financial reform aimed specifically at the Big Banks. The European Union is also pursuing similarly ambitious changes aimed at preventing another crisis in the future.
At the World Economic Forum in Davos, Switzerland, where more than forty heads of state met, the proposals for financial regulatory reform were part of the focus of deliberation.
There is undeniably an inexorable drive on both sides of the Atlantic to find new ways to tighten bank and capital market regulations in response to an international financial crisis triggered by the bursting of a U.S. property price bubble and the resulted global domino effects.
Foreigners to Blame?
The financial crisis of 2007–2010 has been called the worst since the Great Depression of the 1930s. Many causes have been proposed and recently, MIT economist Ricardo Caballero made a suggestion that caught the attention of TIME:
"There is no doubt that the pressure on the U.S. financial system [that led to the financial crisis] came from abroad….Foreign investors created a demand for assets that was difficult for the U.S. financial sector to produce. All they wanted were safe assets, and [their ensuing purchases] made the U.S. unsafe."
Did foreign investment demand really “make the U.S. unsafe”? Let’s go back and take a closer look.
Close Point of Origin – Housing
Most economists and pundits seem to agree that the collapse of the U.S. real estate market in 2006 was the close point of origin of the crisis. The housing bubble bursting caused the values of securities tied to real estate pricing to plummet, thus damaging financial institutions globally.
Sophistication Beyond Comprehension
Critics argued that credit rating agencies and investors failed to accurately price the risk involved with mortgage-related financial products, and that governments did not adjust their regulatory practices to address the 21st century financial markets.
However, the entire financial system had become fragile as a result of one factor, among others, that is unique to this crisis - the transfer of risky assets from banks to the markets through creation of complex and opaque financial products.
In fact, these derivative products are so complex that they mystified even Alan Greenspan, the former chairman of the Federal Reserve.
Unknowing & Unwilling Participants
The banks’ strategy of unloading risk off balance sheets backfired when investors, foreign or otherwise, finally became aware of the complexity and risk underlying these asset backed securities.
A vicious cycle of asset liquidation and price declines was set in motion thereafter as these securities were brought back into the balance sheets, banks had to record losses based on the fair value accounting. Global financial integration made possible for the crisis to spread virtually worldwide.
So, how did we get here?
FSMA – Root of Crisis
The root cause of the financial crisis that led to the current recession may be traced back to the Financial Services Modernization Act of 1999 (FSMA), also know as the Gramm-Leach-Bliley Act (GLBA). The FSMA essentially repealed part of the Glass-Seagull Act of 1933 that prohibited the integration of investment bank, a commercial bank, and/or an insurance company into one entity.
The repeal fostered the consolidation of banks, securities firms and insurance companies, which ultimately lead to “too big to fail.” As a result, these institutions have bulked up their profits primarily through areas far beyond the traditional banking. Some have bought or sponsored hedge funds, while others have moved to invest their own money in the markets.
The investment banking units, far more profitable than the banking operations, have grown dramatically since the FSMA, and the related excessive risk taking along with the subsequent offloading to market played a far more significant role than others in the crisis.
Bigger & Back to Risk
After the collapse of Lehman Brothers about 18 months ago, many of these Wall Street companies were in danger of going under only to be rescued by federal bailout programs. The Trouble Asset Relief Program (TARP) practically guaranteed banks easy profit by providing capital at virtually zero interest cost.
Now, big banks are getting even bigger after scooping up smaller competitors weakened by the housing collapse. According to Bloomberg, the six biggest financial institutions now hold assets equivalent to 62% of the economy, up from 58% before the crisis and 20% in 1994.
There are also indications that some big financial institutions are going back to the same risk taking practices that got us into this crisis. The USA Today recently pointed to an independent research by the Demos highlighting that through the third quarter of last year, big banks were increasingly reliant on trading revenue and were taking on more risk in their investment portfolios.
In essence, government guarantees designed to spur lending by letting banks borrow cheaply were instead funding banks' speculative investments and fueling soaring profits.
Their size and complexity raise the risk of a future financial crisis.
Foreigners Do Not Bring Systemic Risk
In the end, foreigners demand did not bring about the systemic risk. It is the lack of check-and-balance in our system allowing a concentration of risk into the hands of a few that almost brought the world to an utter collapse.
The drivers for enacting the Glass-Seagall Act in 1933 are the same as those for financial reform in 2010. However, a meaningful and globally consistent financial reform seems unlikely amid divided politicians and special interests fighting for short-term advantage.
Endgame and checkmate could come when unfettered financial institutions again push the economy to the brink, and there is no resources left for another bailout or rescue.
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RSDallas - agree with you on the causes. To the extent probability and severity can be separated, the PROBABILITY of a cris was significantly raised by bad lending and in some cases, outright fraud(ie horrific underwriting standards). These deteriorated to the point that it became a certainty that a "bad loan crisis" was goint to happen. However regarding the SEVERITY and global impact of the crisis, this was significantly worsened by the "transimission mechanism" referred to by Caballero, ie the vast quantity of repackaged cash and synthetic transactions referencing those "bad loans". And why was that? That's a big question and the answer HAS to be connected with investor demand for AAA credit assets. This demand spurned the whole CDO of Mezz , CDO^2, CPDO, etc phenomeno which ultimately devastated the financial system. At a macro level, its worth analyzing the phenomenon seriously, even if you ultimately disagree with Caballero et al.
I'm finishing Reinhart & Rogoff's latest book "This Time Is Different" and they try to make a case for this as well. Actually they make a rather weak case. I think they just wanted to have a reason to mention their buddy Krugmans name. I definitely agree with that the origin of the debacle can be traced to the liberalization of the financial system in more ways than just the FSMA.
For me, what's amazing about this financial crisis is it's simplicity. A bunch of people made a bunch of bad loans, gift wrapped them and sold them around the world. People forget that most lenders align their underwriting guidelines with those of Fannie & Freddie, because many of them ultimately sold their loans to Fannie & Freddie.
What I want to know is who was responsible for their utter collapse of their basis underwritting guidelines of income verification, job verification, income to debt ratios etc etc? My guess is that the blame lies with the our law makers. This is what caused this financial collapse.
The current financial crisis was largely caused by the internet allowing for globalization. Efforts to delay the inevitiable lowering in the USA standard of living have resulted in multiple bubbles, which has now moved to Treasuries. In the 1930, the introduction of tractors and trucks on farms replace millions of mules/horses which freed up millions of acres that was previously used for pasture to be planted which resulted in excess supply and a collaspe in crop prices. Farm land prices collasped and the depression was on. It lasted until 1945 and only ended with a world war. That's real story of the previous and coming depressions. Bennie is only putting his finger in the dam. It will break.
Can't believe there are people who post stuff without having any clue of what they're saying. Ever heard of wasting time? How many of you have READ caballero's article (not that many of you would understand much, judging from the intellectual value added of your comments). Caballero is NOT "blaming" foreigners in the Kindergarten sense which you seem to assume, but rather saying that in a world of supply and demand, there was a very high DEMAND for AAA assets, much of which was foreign. If you losers can't dispute that with an intelligent argument, why don't you us all a favour and shut up and / or educate yourselves?
You must be a spic.
Let us see now, no money just paper (toilet is more useful, paper that is) and what do we get? Fraud global scale. Na.
It is the 21st Century and with billions of humans in need of food, clothing, shelter, there are those who continue to sell marbles as though gold and paper as though money.
What intelligence.
Maybe the humans who can think, solve the problem of trading for money since this exchanging of commodities has been around forever, however, it does not appear after all these years to function properly.
Wondering about humans who manufacture the value of trade and exchange on a finite planet of humans copulating into the perpetuity of no tomorrows.
Flesh is the best to shred and bet on, to-date.
Time for some fresh ideas of mark-to-market.
Beautiful. Some spic named Ricardo Caballero blames it on foreigners.
"Endgame and checkmate could come when unfettered financial institutions again push the economy to the brink, and there is no resources left for another bailout or rescue."
No resources, the Federal Reserve owns the printing press. USD availability is literally limitless.
Well, that is until that whole FAITH thing breaks down. Until then, a fool and his FIAT currency are happy together.
Got gold?
"Give me control over a nations currency, and I care not who makes its laws" -- Baron M.A. Rothschild, same guy who helped create the central banking system used today.
Evil foreigners and their savings glut!
How can poor little US investment banks say no with so much cash being thrown at them? It would be downright uncapitalist to remain honest when so many suckers would pay top dollar for a piece of toilet paper, if the Moody's skidmark resembled the letters 'AAA'.
Evil foreigners and their savings glut!
How can poor little US investment banks say no with so much cash being thrown at them? It would be downright uncapitalist to remain honest when so many suckers would pay top dollar for a piece of toilet paper, if the Moody's skidmark resembled the letters 'AAA'.
Caballero stating that foreigners created this crisis is as disengenuous as Greenspan blaming free markets for this crisis. Both are way off the mark and the exact opposite of the truth. But we can always count on the financial/academic elites to bash foreigners for our problems even though our problems were home-grown (and UK grown). The only people these financial shills will fool are the unthinking pod people. Solid analysis.
Ummm, what kind of explanation is that ?? No underlying logic, just a few loosely connected factoids of the USA Today variety. There is no counter-explanation to Caballero's argument. Further, you show a misunderstanding of how investment banks do their business, when you write that:
"related excessive risk taking along with the subsequent offloading to market played a far more significant role than others in the crisis. "
Actually no. First, banks have always taken "excessive" risk of the credit variety,(once again, one of the people who seems to vanilla lending is non-risky, despite 8 centuries history of lending blowups). But more fundamentally the misunderstanding is that banks did the opposite of what you claim. As anyone who works in a Bank doing structured credit can explain, banks sourced and repackaged the assets to take advantage of investor demand for high yielding assets. Taking prop risk on these assets was a (misguided)consequence of this investor-driven business. This is why Caballero, who asks why there was such high demand for AAA CDOs in the first place, raises a good question. While your "answer" is uh, very poor.
One thing is for foreign investors to demand AAA CDOs but at the end of the day, it's the banks that packaged the products in a complex and convoluted way as to make them seem high quality when they were not.
If they didn't have the AAA tag, there would have been far less demand for said assets
Are foreigners to blame? Of course they are! The Russians did it, don't you know? That's right...the Russians! Just ask Hank.
http://rawstory.com/2010/01/paulson-russia-exacerbate-financial-crisis/
we are all responsible for our own orgasms
If you order a hit one somebody.
Does this make the person who pulls the trigger no longer a assasin but a victim also?
This article is BS
Really? Really? It seems harsh to fault our noble waterfowl.
If you throw up some bread, they'll concentrate on swooping down to get it instead of ruining our financial system. I'm all for the new financial reform bill "crusts for seagulls act of 2010".