4/21/2018 25 Major Factors That Caused or Contributed to the Financial Crisis

25 Major Factors That Caused or

Contributed to the Financial Crisis
While it's always tempting to boil things down to one or two root causes, the
reality is that financial crisis of 2008-09 was caused by a confluence of
dozens of factors.
John Maxfield (JohnMaxfield37)
Feb 28, 2015 at 7:09AM

Most people have an opinion about what or who caused the financial crisis of 2008-09. It was
securitization. Or greed. Or deregulation. Or any number of other things that, truth be told, probably
did play a role in the unusually severe economic downturn.

https://www.fool.com/investing/general/2015/02/28/25-major-factors-that-caused-or-contributed-to-the.aspx 1/31
4/21/2018 25 Major Factors That Caused or Contributed to the Financial Crisis

But after reading a good portion of the books written about the crisis from a variety of viewpoints --
journalists, regulators, and private-sector participants -- I've concluded that it can't be boiled down to
one, two, or even a handful of root causes. It was instead the product of dozens of factors. Some of
these are widely known, but many others are not.

I was reminded of this after flipping through former-FDIC chairman William Isaac's book on the
crisis Senseless Panic: How Washington Failed America. In the back of Isaac's book, I wrote out a
list of 39 factors that played an important role in not only allowing the subprime-mortgage bubble to
inflate, but also in allowing its deflation to wreak such havoc. What follows, in turn, is a scaled-down
version of this list.

1. Mark-to-market accounting. In the early 1990s, the Securities and Exchange Commission and
the Financial Accounting Standards Board started requiring public companies to value their assets
at market value as opposed to historical cost -- a practice that had been discredited and abandoned
during the Great Depression. This pushed virtually every bank in the country into insolvency from an
accounting standpoint when the credit markets seized in 2008 and 2009, thereby making it
impossible to value assets.

2. Ratings agencies. The financial crisis couldn't have happened if the three ratings agencies --
Standard & Poor's, Fitch, and Moody's -- hadn't classified subprime securities as investment grade.
Part of this was incompetence. Part of it stemmed from a conflict of interest, as the ratings agencies
were paid by issuers to rate the securities.

3. Infighting among financial regulators. Since its inception in 1934, the FDIC has been the most
robust bank regulator in the country -- the others have, at one time or another, included the Office of
the Comptroller of the Currency, the Federal Reserve, the Office of Thrift Supervision, the Securities
and Exchange Commission, the Federal Savings and Loan Insurance Corporation, and an
assortment of state regulatory agencies. But thanks to infighting among regulators, the FDIC was
effectively excluded from examining savings and investment banks within the OTS's and SEC's
primary jurisdiction between 1993 and 2004. Not coincidentally, those were the firms that ended up
wreaking the most havoc.

4. Securitization of loans. Banks traditionally retained most of the loans that they originated. Doing
so gave lenders incentive, albeit imperfectly, to underwrite loans that had only a small chance of
defaulting. That approach went by the wayside, however, with the introduction and proliferation of
securitization. Because the originating bank doesn't hold securitized loans, there is less incentive to
closely monitor the quality of underwriting standards.

5. Credit default swaps. These are fancy financial instruments JPMorgan Chase developed in the
1990s that allowed banks and other institutional investors to insure against loan defaults. This
situation led many people in the financial industry to proclaim an end to credit risk. The problem, of
course, is that credit risk was just replaced by counterparty risk, as companies such as American
International Group accumulated far more liability than they could ever hope to cover.

https://www.fool.com/investing/general/2015/02/28/25-major-factors-that-caused-or-contributed-to-the.aspx 2/31
4/21/2018 25 Major Factors That Caused or Contributed to the Financial Crisis

6. Economic ideology. As the 1970s and '80s progressed, a growing cohort of economists began
proselytizing about the omniscience of unrestrained free markets. This talk fueled the deregulatory
fervor coursing through the economy at the time, and it led to the belief that, among other things,
there should be no regulatory body overseeing credit default swaps.

7. Greed. The desire to get rich isn't a bad thing from an economic standpoint. I'd even go so far as
to say that it's necessary to fuel economic growth. But greed becomes bad when it's taken to the
extreme. And that's what happened in the lead-up to the crisis. Homeowners wanted to get rich
quick by flipping real estate. Mortgage originators went to great lengths, legal and otherwise, to
maximize loan volumes. Home appraisers did the same. Bankers were paid absurd amounts of
money to securitize toxic subprime mortgages. Rating agencies raked in profits by classifying
otherwise toxic securities as investment-grade. Regulators were focused on getting a bigger
paycheck in the private sector. And politicians sought to gain popularity by forcing banks to lend
money to their un-creditworthy constituents.

8. Fraud. While very few financiers have been prosecuted for their role in the financial crisis, don't
interpret that to mean that they didn't commit fraud. Indeed, the evidence is overwhelming that firms
up and down Wall Street knowingly securitized and sold toxic mortgage-backed securities to
institutional investors, including insurance companies, pension funds, university endowments, and
sovereign wealth funds, among others.

9. Short-term investment horizons. In the lead-up to the crisis, analysts and investors castigated
well-run firms such as JPMorgan Chase and Wells Fargo for not following their peers' lead into the
riskiest types of subprime mortgages, securities, and derivatives. Meanwhile, the firms that
succumbed to the siren song of a quick profit -- Citigroup, for instance -- were the first to fail when
the house of cards came tumbling down.

10. Politics. Since the 1980s, bankers and politicians have formed an uneasy alliance. By
conditioning the approval of bank mergers on the Community Reinvestment Act, politicians from
both sides of the aisle have effectively blackmailed banks into providing loans to un-creditworthy
borrowers. While banks and institutional investors absorbed the risks, politicians trumpeted their
role in expanding the American dream of homeownership.

11. Off-balance-sheet risk. Why did investors allow financial firms to assume so much risk? The
answer is that no one knew what they were up to because most of the risky assets weren't reflected
on their balance sheets. They had been securitized and sold off to institutional investors, albeit with
residual liability stemming from warranties that accompanied the sales, or were corralled in so-
called special-purposes entities, which are independent trusts that the banks established and
administered. Suffice it to say that all of the residual liability flooded back onto the banks' balance
sheets only after the you-know-what hit the fan.

12. Bad economic assumptions. As moronic as it seems in hindsight, it was generally assumed
before the crisis that home prices would never decline simultaneously on a nationwide basis. This

https://www.fool.com/investing/general/2015/02/28/25-major-factors-that-caused-or-contributed-to-the.aspx 3/31
4/21/2018 25 Major Factors That Caused or Contributed to the Financial Crisis

belief led underwriters of and investors in mortgage-backed securities to believe that geographically
diversified pools of mortgages were essentially risk-free when they obviously were not.

13. High oil prices. Beginning with the twin oil embargoes of the 1970s, oil-producing countries
began accumulating massive reserves of so-called petrodollars which were then recycled back into
the U.S. financial system. This situation pressured banks and other types of financial firms to put the
money to work in increasingly marginal ways, such as subprime mortgages.

14. A broken international monetary system. One of the most underappreciated causes of the
financial crisis was the trade imbalance between the developing and developed worlds. By keeping
their currencies artificially depressed versus the U.S. dollar -- which is done by buying dollars with
newly printed native currencies -- export-oriented nations such as China accumulated massive
reserves of dollars. Like the petrodollars of the 1980s and '90s, these funds were then recycled
back into the U.S. financial system. To put this money to use, financial firms had little choice but to
lower underwriting standards and thereby grow the pool of potential borrowers.

15. The rescue of Bear Stearns. In March 2008, the Federal Reserve saved Bear Stearns with a
last-minute $30 billion loan supplied through JPMorgan Chase. As opposed to failing, the nation's
fifth-largest investment bank at the time ended up being sold for $10 a share. The problem with the
rescue, however, was that it reduced the incentive on Lehman Brothers CEO Dick Fuld to find a
private-sector solution to its even bigger, and eventually fatal, problems. In hindsight, it seems
relatively clear that the Fed should have either let Bear Stearns fail or, much more preferably, bailed
both of them out.

16. Lehman Brothers' bankruptcy. Allowing Lehman Brothers to fail was a mistake of epic
proportions. History clearly demonstrates that the downfall of a major money-center bank -- be it a
commercial or investment bank -- almost always triggers wide-scale financial panics. In 1873, it was
Jay Cooke & Company. In 1884, it was Grant & Ward. In 1907, it was the Knickerbocker Trust
Company. I could go on and on with examples. The point being, despite the admittedly unsavory
thought of bailing out someone as aggressively offensive as Dick Fuld, it would have been a small
price to pay to avoid the subsequent economic carnage.

17. The "Greenspan put." For two decades following the stock market crash of 1987, the Federal
Reserve, guided by then-Chairman Alan Greenspan, lowered interest rates after every major
financial shock, a trend that became known as the Greenspan put. It was this strategy, intended to
stop financial shocks from transforming into economic downturns, that led the central bank to drop
the Fed funds rate after the 9/11 terrorist attacks. And it was this drop that provided the oxygen, if
you will, to inflate the housing bubble.

18. Monetary policy from 2004 to 2006. Just as low interest rates led to the housing bubble, the
Fed's policy of raising rates from 2004 to 2006 eventually caused it to burst.

19. Basel II bank capital rules. Any time an economy experiences a severe financial shock, one of
the biggest problems is that undercapitalized banks will be rendered insolvent. That's true in part
https://www.fool.com/investing/general/2015/02/28/25-major-factors-that-caused-or-contributed-to-the.aspx 4/31
4/21/2018 25 Major Factors That Caused or Contributed to the Financial Crisis

because of the absurd application of mark-to-market accounting during periods of acute stress in
the credit markets, and in part because banks are highly leveraged, meaning that they hold only a
small slice of capital relative to their assets. The so-called Basel II capital rules, which took effect in
2004, accentuated this reality. The rules allowed banks to substitute subordinated debt and
convertible preferred stock in the place of tangible common equity. The net result was that tangible
common equity at certain major U.S. banks declined to less than 4% on the eve of the crisis.

20. Fannie Mae and Freddie Mac. Much has been written about the role Fannie Mae and Freddie
Mac played in the lead-up to the financial crisis, so I won't dwell on it here. In short, the problem
was that these two quasi-public corporations became so focused on growth at all costs that they
abandoned any semblance of prudent risk management. Doing so allowed mortgage-brokers-cum-
criminal enterprises such as Countrywide Financial and Ameriquest Mortgage to stuff the
government-sponsored entities to the gills with shoddily originated subprime mortgages.

21. The failure of IndyMac Bank. The $32 billion IndyMac Bank was the first major depository
institution -- it was technically a thrift as opposed to a commercial bank -- to fail during the crisis
when the Office of Thrift Supervision seized it on July 11, 2008. In a situation like this, the FDIC
traditionally insures all depositors and creditors against losses, irrespective of the insurance limit.
But in IndyMac's case, it didn't. The FDIC chose instead to only guarantee deposits up to $100,000.
Doing so sent a shockwave of fear throughout the financial markets and played a leading role two
months later in the debilitating run on Washington Mutual.

22. The failure of Washington Mutual. By the time Washington Mutual failed in September 2008,
the FDIC had recognized its mistake in dealing with IndyMac Bank. But this time around, while the
FDIC covered all deposits irrespective of the insurance limit, it allowed $20 billion of WaMu's bonds
to default. After that, banks found it difficult, and in many cases impossible, to raise capital from
anyone other than the U.S. government.

23. Pro-cyclical regulation of loan loss reserves. The more one learns about the causes of the
financial crisis, the more one appreciates how incompetent the Securities and Exchange
Commission is when it comes to regulating financial institutions. In 1999, the SEC brought an
enforcement action against SunTrust Banks, charging it with manipulating its earnings by creating
excessive loan loss reserves. At the time, default rates were extremely low, leading the SEC to
conclude that SunTrust shouldn't be reserving for future losses. Banks took note and no longer set
aside reserves until specific future losses are likely and can be reasonably estimated -- by which
point, of course, the proverbial cat is already out of the bag.

24. Shadow banking. While hundreds of traditional banks failed in the wake of the financial crisis,
they share little responsibility for what actually happened. That's because shadow banks -- i.e.,
investment banks and thrifts that didn't fall under the primary regulatory purview of the Federal
Reserve, FDIC, or, to a lesser extent, the Office of the Comptroller of the Currency -- caused most
of the damage. Here's Richard Kovacevich, the former chairman and CEO of Wells Fargo,
addressing this point in a speech at the end of last year:
https://www.fool.com/investing/general/2015/02/28/25-major-factors-that-caused-or-contributed-to-the.aspx 5/31
4/21/2018 25 Major Factors That Caused or Contributed to the Financial Crisis

If you don't remember anything else I say today, please remember this: Only about 20 financial
institutions perpetrated this crisis. About half were investment banks, and the other half were
savings and loans. Only one, Citicorp, was a commercial bank, but [it] was operating more like an
investment bank. These 20 failed in every respect, from business practices to ethics. Greed and
malfeasance were their modus operandi. There was no excuse for their behavior, and they should
be punished thoroughly, perhaps even criminally.

25. Ignorance of history. When it comes to the financial system, it can't be said often enough that
history repeats itself time and time again. The financial crisis of 2008-09 may seem unique, but it
was only the latest in a series of eerily similar crises that have struck the U.S. economy since the
country was founded more than 200 years ago. In short, crises like these don't have to be
inevitable. But they will continue to be so if every other generation's leading financiers don't spend
some time in the library learning about the mistakes of their predecessors. As former FDIC
Chairman Irving Sprague put it, "Unburdened with the experience of the past, each generation of
bankers believes it knows best, and each new generation produces some who have to learn the
hard way."

Something big just happened

I don't know about you, but I always pay attention when one of the best growth investors in the
world gives me a stock tip. Motley Fool co-founder David Gardner and his brother, Motley Fool CEO
Tom Gardner, just revealed two brand new stock recommendations. Together, they've tripled the
stock market's return over the last 13 years.* And while timing isn't everything, the history of Tom
and David's stock picks shows that it pays to get in early on their ideas.

Click here to be among the first people to hear about David and Tom's newest stock
recommendations.

*Stock Advisor returns as of April 2, 2018

John Maxfield has no position in any stocks mentioned. The Motley Fool recommends American International
Group, Bank of America, and Wells Fargo. The Motley Fool owns shares of American International Group,
Bank of America, Apple, Citigroup Inc, JPMorgan Chase, and Wells Fargo and has the following options: long
January 2016 $30 calls on American International Group, short April 2015 $57 calls on Wells Fargo, and short
April 2015 $52 puts on Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may
not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better
investors. The Motley Fool has a disclosure policy.

This Stock Could Be Like Buying Amazon in 1997

Imagine if you had bought Amazon in 1997… a $5,000 investment then would be worth
almost $1 million today.

https://www.fool.com/investing/general/2015/02/28/25-major-factors-that-caused-or-contributed-to-the.aspx 6/31