Causation Analysis: What “But Fors” Caused the Crisis ?

They’re back!

The usual crowd of ne’er-do-wells are seeking to divert attention from their own roles in the crisis, and shift blame elsewhere. These people make up a big chunk of the Its All Fannie’s Fault! crew. By muddying the waters, they hope to avoid retribution for their own roles in what occurred.  As the mid-term election approaches, we should expect to hear more from this crowd.

The reality of crisis causation is far more complex and nuanced. Looking at the many factors that independently contributed to the collapse, and prioritizing them by degree of causation is not easy. A sophisticated approach is required to separate the prime and secondary factors.

Rather, than just repeat my list of factors what were the causal factors, today I want to try a different approach. Let’s do a “Causation Analysis” of the biggest factors to see if we can determine not just the various elements that contributed to the credit collapse, but which factors actually caused it to occur and what merely exacerbated the collapse, making it worse.

Understand that this is a theoretical discussion based on counter-factuals — what is likely to have occurred if various elements leading up to the crisis were different. We are trying to discern the differences between primary and secondary factors, separating the causes from the exacerbators.

Whenever someone asserts as a cause an event or force relative to a particular outcome, you should always ask: “Is this a “BUT FOR cause of that outcome?” In terms of a specific result or outcome, “But for” this factor, how would the outcome have changed? Would the result have been the same or different?

My top 3 list of crisis “BUT FORs” are:

1) Ultra low rates;
2) Unregulated, non bank, subprime lenders;
3) Ratings agencies slapping AAA on junk paper.

Why are these “But Fors?” But for these things occurring, the crisis would not have happened:

-If it wasn’t for ultra low rates, the housing boom would likely have been much more modest; further, bond managers would not have been scrambling for yield, and searching for alternative products to low yielding Treasuries;

-If it wasn’t for the sub-prime lenders, the credit bubble would not have inflated; further, millions of unqualified borrowers would not have been able to purchase homes they could not afford;

-If it wasn’t for the ratings agency fraud, the enormous market for this high yielding junk paper — mislabeled as AAA — would not have existed; further, the primary purchasers were firms that were only permitted to buy investment grade bonds. No A+ or better rating, no sale.

Hence, these factors are huge causative elements — BUT FOR them, there is no boom and bust, no crisis and collapse. Bond managers could not have owned all of these securitized sub-prime mortgages; the credit default swap market would have been much smaller, perhaps 1/10 its size; Sovereign wealth funds around the world could not have purchased all this bad paper; Iceland does not collapse. That is these are the big 3 — why I label them the prime cause of the crisis.

There is a secondary list of things that might or might not be prime causal factors; at the very least, they made the crisis significantly worse:

1) The Commodity Futures Modernization Act of 2000
2) Net Cap Rule Change of 2004 (aka Bear Stearns exemption)
3) Repeal of Glass Steagall (1998)

Lets look at each of these:

1) The Commodity Futures Modernization Act of 2000 (CFMA) exempted derivatives from all oversight and regulation. It allowed derivatives to be traded in the shadows, unreserved for, off exchanges, no disclosures of counter parties, no capital requirements. Did that cause the crisis? I do not think it is the primary cause, but I am not sure.

-It certainly allowed AIG FP to destroy the parent company;
-Did it make things much worse? Definitely!
-Is it a “But For”? Would the collapse have happened without this? I believe its inconclusive, and could easily go either way.

We can easily accept that the collapse of AIG was a major cause of the crisis, but if you were to argue that it didn’t cause it, but only served to make mattes much worse, I’m not sure I really disagree with you.

2) The 2004 Net Cap rule exemption that allowed banks to go from 12 to 1 leverage to 25, 35 even 40 to 1 leverage — again, I am unsure if it is a direct causation of the credit freeze. The basic argument pro is that BSC and LEH might not have been in as dire straits BUT FOR this leverage, and each might have survived, this making the crisis more manageable. No doubt that the increased leverage certainly made the damages much greater.

Is it a BUT FOR? I have a hard time deciding, as it can go either way . . .

3) The repeal of Glass Steagall allowed banks to get much bigger than they would have — which made their losses that much bigger; Another maybe/maybe not on whether it is a BUT FOR.

Citi, Bank of America, and the rest of the TARP recipients would have losses — but for Glass Steagall repeal, they most likely would have been much smaller.

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Here’s the kicker — when I do the same BUT FOR analysis on Fannie/Freddie, It get different results.

-Were they an accounting fraud run by weasels? Yes.
-Did they securitze mortgages? Yes, for decades.
-What about securitizing sub-prime mortgages? Primarily after late 2005. By then, the die had been cast.

So are Fannie & Freddie a “BUT FOR” ?

I don’t see how. Wall Street had been securitizing most of the sub-prime mortgages for years without the GSEs — Fannie and Freddie jumped in very late because they were losing market share. Their timing was perfect they started doing nonconforming mortgages just as the market peaked.

And if Fannie & Freddie didn’t exist, mortgage securitization would have happened anyway, the way it did in areas where their were no GSEs — securitized credit card receivables, auto loans, small biz loans, etc. took place without GSEs. I assume there would likely have been a private sector version for conforming loans, the way there was a private sector securitizing response to the demand for non-conforming (sub-prime) loans.

That’s how I end up saying they were not a prime cause of the crisis.

Of course, they certainly made things worse — but so did a lot of other entities. But the key question for the blame Fannie/Freddie crowd is “Would the crisis has happened without them?”  The answer is yes — FRE/FNM were not BUT FORs, because all of this was happening anyway, prior to their participation in subprimes late 2005.