The 2008 financial crisis was not the result only of moral hazard; nor was it unforeseeable. While banks believed they would be bailed out, consumers, rating agencies, and policymakers all bet on housing as well, destabilising the system

By Nicola Gennaioli and Andrei Shleifer*

Over the last decade, research by many economists, including us, arrived at a broadly shared narrative of the 2008-2009 financial crisis. As we describe in our new book, A Crisis of Beliefs: Investor Psychology and Financial Fragility, the fundamental cause of the crisis was the deflation of the housing bubble, starting in early 2007. For several years until then, home prices in the United States rose dramatically, fueled by massive borrowing by homebuyers and banks’ investments in mortgages and mortgage-backed securities. As the housing bubble burst, both borrowers and bankers suffered.

By mid-2008, banks were projected to lose hundreds of billions of dollars. After months of growing losses, bankruptcies, and market freezes, the financial system finally cracked. Lehman Brothers declared bankruptcy, and many other firms had to be saved by the government. In short order, the financial woes of banks and consumers dragged the economy into the Great Recession.

This widely accepted and well-documented narrative highlights two misconceptions in the current retrospectives of the crisis. These misunderstandings may seem purely academic, but they are not. They have major consequences for the ability of policymakers to prevent future crises.

The first misconception is that the crisis was all about moral hazard. Few things are more popular than blaming the banks for the crisis. The banks pushed unsuspecting consumers into risky mortgages, fueling the housing bubble in the first place, and then bet on the bubble themselves, knowing that should things turn sour, the government would bail them out. They were, after all, too big to fail.

It is surely the case that the banks, along with rating agencies, mortgage underwriters, investment banks, and others, engaged in unsavory practices. But the moral hazard view misses the central point: as we document in our book, households, banks, rating agencies, investors, and policymakers all believed in the housing market, and all failed to see the risks.

The banks believed what consumers believed as well – that housing was a good bet. The stock market rewarded banks that made that bet. The first-order cause of the bubble and the crisis was neither trickery nor hidden risk taking. It was a belief about housing that most market participants embraced.

The second misconception is that the crisis could not be anticipated. This argument is most popular with policymakers who acknowledge that they failed to see what was coming. As Timothy Geithner, President Barack Obama’s Treasury Secretary, put it in his memoir, “Financial crises can’t be reliably anticipated or preempted.” Likewise, Hank Paulson, Geithner’s predecessor under President George W. Bush, recently said, “my strong belief is that these crises are unpredictable in terms of cause or timing or the severity when they hit.”

One version of this view holds that the Lehman failure resulted from an unpredictable run, with investors rushing all at once to withdraw short-term financing from the banks. “This crisis involved a 21st century electronic panic by institutions,” as former Federal Reserve Chairman Ben Bernanke put it. In other words, “it was an old-fashioned run in new clothes.”

The evidence does not support this view. Our book shows that deflating asset bubbles, particularly in housing markets, pose a serious danger to the financial system. When highly leveraged banks and other institutions face the abyss of massive losses, the probability of a panic rises sharply. In this respect, the 2008 crisis looked very much like all the others.

The deflation of the housing bubble implied massive losses for banks. The International Monetary Fund predicted that US banks would lose hundreds of billions of dollars by the summer of 2008, well before Lehman collapsed. Several institutions, including Bear Stearns, had to be rescued earlier that year. The Lehman failure did precipitate a fast and furious run that was hard to stop once it started. But its occurrence was a growing possibility for months. It did not come out of the blue.

One reason it may have felt that way is that, as late as August 2008, the Fed expected only a small slowdown of the US economy should home prices continue falling. The crisis was a surprise to investors and policymakers because they gravely underestimated the risks building up in the financial system. Lehman was a heart attack, but the patient was already terminally ill.

The two misconceptions about the crisis have the unfortunate effect of preventing us from learning a key lesson: economic policy prior to Lehman Brothers’ collapse should have been more aggressive. Moral hazard claims excuse inaction because “it was the bad banks taking and hiding extravagant risks.” Likewise, claims of unpredictability excuse passivity. In reality, the fragility of the financial sector had been building up for more than a year before Lehman. The continuing optimism of Fed forecasts, and the reluctance to force banks to shore up their capital – often clothed in too-big-to-fail-rhetoric – amounted to serious policy failures.

Policymakers showed great courage and skill in acting after the Lehman catastrophe. But we should not forget their failure to act before it. Stopping financial bubbles is difficult. Acting early and aggressively to protect the system once the bubbles start deflating would help contain future crises.


Nicola Gennaioli is Professor of Finance at Bocconi University, Milan. Andrei Shleifer is Professor of Economics at Harvard University. Copyright: Project Syndicate, 2018, published here with permission.

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11 Comments

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It is sad that in an article in which an economist laments that lessons have not been learnt, the economist still thinks it is ok to allow a bubble to grow in the first place. The debate should not be about whether to act aggressively when they start deflating or after they have burst. The debate should be in their prevention
In regard to housing bubbles, it is clear they can be prevented if banks are forced by regulators to maintain prudent lending standards throughout the whole cycle, by stable permanent LVR and DTI limits set at meaningful levels, and tailored for each sector. The limits for FHB's buyer with a cash deposit being less stringent than the owner-occupier, with tightest limits around "investors" who do not use cash for purchases but equity from their houses.

Thought the same thing.

The writer seems to be suggesting don’t do anything about the state of the road – but let’s have an ambulance permanently stationed at the bottom of the cliff instead.

Peri and Custard, hence why we see no improvement with any government. A clear inability to identify the actual causes. I bang on about it a lot but our money creation model facilitated banks greed and the bubble!

I dont think they've understood what happened at all. The 2008 collapse was severe because of the fragility of the opaque security products the banks were trading with each other and the global interconnectivity of the financial system but they were not the root cause of the problem.

The root cause was the weak response of the US economy to the low interest rate environment established by the US Fed post the 2001 dot com crash.

It was weak because of all the domestic demand being sucked out of the economy by China. China's lending to the US was expanding at this time and the US was happily exporting demand and jobs in return for cheap consumer goods.

The low interest rate environment made possible the loans that sparked the housing bubble and new housing investment soaked up the unemployed workers displaced by exported demand.

Housing bubbles occurred gloabally and in places where mortgage securitization was not a factor. The common factor to all the housing bubbles was large trade deficits. Greece, Spain, ltally Portugal all had housing bubbles. Germany did not. This is a very similar dynamic to the relationship between China and the US except the fixed common currency made it much worse.

One big thing Donald Trump is right about, even if he cant explain it very well, is that trade deficits are connected to jobs and demand. This is not so true for a small specialsed and open island economy like NZ but it is true for a large diverse economy like the US.

I dont think they've understood what happened at all. The 2008 collapse was severe because of the fragility of the opaque security products the banks were trading with each other and the global interconnectivity of the financial system but they were not the root cause of the problem.

The root cause was the weak response of the US economy to the low interest rate environment established by the US Fed post the 2001 dot com crash.

It was weak because of all the domestic demand being sucked out of the economy by China. China's lending to the US was expanding at this time and the US was happily exporting demand and jobs in return for cheap consumer goods.

The low interest rate environment made possible the loans that sparked the housing bubble and new housing investment soaked up the unemployed workers displaced by exported demand.

Housing bubbles occurred gloabally and in places where mortgage securitization was not a factor. The common factor to all the housing bubbles was large trade deficits. Greece, Spain, ltally Portugal all had housing bubbles. Germany did not. This is a very similar dynamic to the relationship between China and the US except the fixed common currency made it much worse.

One big thing Donald Trump is right about, even if he cant explain it very well, is that trade deficits are connected to jobs and demand. This is not so true for a small specialsed and open island economy like NZ but it is true for a large diverse economy like the US.

I strenuously disagree with some of the viewpoints in this missive.

This statement "The first misconception is that the crisis was all about moral hazard" is rather amusing in its inaccuracy. The crisis had absolutely zero to do with moral hazard. The response to the crisis is another issue... well, I really hope that hell has some rational economists that will assess Bernanke in regards to how his responses to bail out banks induced a moral hazard. We are still collecting the bills in regards to this.

I have to laugh about the second "misconception". The housing bubble was rather easy to see happening for anyone that wasn't willfully wearing blinders. I saw it coming, and profited from it via selling our house at the high mark and renting while the housing prices declined.

Can anyone explain this sentence? "Moral hazard claims excuse inaction because “it was the bad banks taking and hiding extravagant risks." The basic definition of moral hazard in this instance is that banks received funding during the collapse so as to return from the extravagant risks taken while chasing higher profits. The "moral hazard" element comes from the idea that the higher the risk taken, the larger the payout. In other words, the banks that were most reckless received the highest funds to continue operation.

There are many causes. The repeal of Glass-Steagal is one of the seeds. The lack of prosecution for financial crimes is another. The too big to fail paradigm is yet another. I so wish that senior politicians would actually consider moral hazard as one of the factors when making an evaluation. Let the company (and directors) be fully responsible for their choices. If their choices result in bankruptcy. so be it.

"Those who do not learn history are doomed to repeat it."
http://creditbubblebulletin.blogspot.com/2018/09/weekly-commentary-porte...

"Those who do not learn history are doomed to repeat it."
http://creditbubblebulletin.blogspot.com/2018/09/weekly-commentary-porte...

I agree with the other commenters, it is a lightweight bit of virtue signalling by self righteous economists. The impression I get is the collapse of Lehmann brothers was a giant mistake pushed through by Hank Paulson and supported by Bernanke and Geithner. Lehman was not insolvent, only the use of inappropriate mark to market accounting in a liquidity crisis made it appear so. They should have advanced sufficient liquidity against good collateral but at penalty rates, as Bagehot suggested. They were completely unaware that Lehman provided the trade credit finance upon which global trade depended. No wonder they ran around like frightened chickens when they realised what they had done after global trade stopped dead. The crisis stopped as soon as Congress suspended mark to market accounting. They should read John Hussman.

All that aside, only an American could come up with such a one eyed view. What about the Eurodollar credit explosion, the impact of the globally destabilising German and Chinese current account surpluses and the equal but opposite capital outflows they created, and the massive expansion of the French and German bank loan portfolios that were used as an excuse to destroy southern Europe? What about America's choice of military imperialism and the loss of productivity it engendered, of which the export of jobs to China was a part?

In my view the securitization of mortgages was a form of moral Hazard.. It allowed the originators of mortgages to avoid the risk of lending money to householders who did not have the ability to repay.. They used dubious methods to induce people to take out mortgages , and then packaged and onsold thoses mortgages in the form of mortgage backed securities.., thus avoiding the risk of their own imprudence...
For me the whole GFC reeked with the smell of Moral Hazard... and the laissez faire attitude did not really stem from a belief that house prices would keep going up but came from a blind greed and a belief that if the shit did hit the fan,,.... the system would get bailed out. ( Greenspan put ) ( there was a blindness to counterparty risk )

Citibanks boss comes to mind with his remark about musical chairs..
https://www.nakedcapitalism.com/2007/07/musical-chairs-theory-of-markets...

I would instead use the word fraud instead of moral hazard. The securitization advertised wonderful ratings, whereas the underlying mortgages were very high risk. Some blame needs to be placed on the people that took out mortgages without any realistic income to pay off the mortgage. Many people bought homes or refinanced to a higher mortgage value assuming that the house price would appreciate more quickly than the mortgage payments. Many of the problematic mortgages were "NINJA" and had a very low interest only payment for a few years, and then would revert to a higher payment. The idea of handing out a loan without any knowledge of the applicants income or whether they even had a job is just... well, amazing. Both sides were complicit in my opinion. Amazing how greed motivates some people...