Causes of the Financial Crisis and the Future of the Financial Services Industry

Event Recap

Geoffrey T. Boisi, chairman and C.E.O. of Roundtable Investment Partners and founding patron of the Boisi Center, spoke on the causes of the crisis and the future of the financial services industry on February 4. While recognizing the complexity of the issue at hand, Boisi pointed to the rapid breakdown in trust between major actors in the U.S. government and the financial sector as the proximate cause of the crisis. He identified this breakdown, in turn, as the culmination of longstanding problems in social policy, innovations in the financial services industry, and monetary policy.                                                            

U.S. government social policy has encouraged home ownership since at least the 1930s, Boisi said. The creation of Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), for example, increased liquidity in the mortgage market, particularly for low-income homebuyers. However, both institutions were created with poor oversight and dysfunctional governing structures. By the early 1990s increased pressure from the federal government to expand home ownership began to exacerbate deficiencies in the governance and regulation of these institutions.

The evolution of services and investment strategies in the finance industry in the latter half of the twentieth century compounded these problems. For instance, the application of securitization to mortgage (and then to non-mortgage) assets tied the American housing market more closely to the financial sector. These innovations were accompanied by what Boisi called a reckless “casino approach” to finance, which focused on short-term trading perspectives and increased profits. The combination of increasing securitization and risky investment strategies led to the widespread acceptance of new rules such as mark-to-market accounting that were hard to apply to securities and other financial products. Rather than relying on seasoned judgment, securities firms began to develop esoteric mathematical models for valuing assets, leading to dangerous capital ratios.

Finally, said Boisi, monetary policy adopted by the Federal Reserve further contributed to existing strains in the system. Lower interest rates, for example, eased credit and helped form bubbles in the market. Cheap credit increased the amount of household credit from 40% of disposable income in 1952 to 133% in 2007. Over-borrowing on the part of individuals—combined with risky practices in the financial sector and structural inadequacies on the part of government institutions—contributed to the building up of the housing bubble and to the eventual crash of the housing market. As housing prices declined, the U.S. government tried to regain control of the market by nationalizing Freddie Mac and Fannie Mae. This action only led to greater instability and lack of trust in the market, and the subsequent collapse.

Boisi concluded by pointing to several hopeful signs in the recovery process, but noted that it will take households two to four more years to recover the wealth lost in the past year. In order to avoid future crises, Boisi pointed to the importance of correcting dysfunctional regulatory structures and of encouraging greater prudence in the finance industry.