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Risk-taking in this corner of the debt markets sounds a bit too familiar

Protesters hold signs behind Richard Fuld, former Chairman and Chief Executive of Lehman Brothers Holdings, on Capitol Hill in Washington, October 6, 2008. REUTERS/Jonathan Ernst

Mark Zandi is the chief economist at Moody’s Analytics.

A decade since the devastating global financial crisis struck, we still don’t have a clear accounting for who’s to blame. Playing the blame game may be somewhat unseemly, but to avoid another crisis it is critical we understand who’s at fault.

There is plenty of blame to go around. The crisis wasn’t the result of one or two missteps, but the conflation of many mistakes. Nearly all of us were sucked into the euphoria of the time.

China’s entry into the World Trade Organization soon after Y2K stands out as a seminal event for the crisis. China quickly became an export juggernaut, shipping much of what it produced to U.S. consumers. China was awash in dollars that it earned in trade and interventions to maintain what at the time was the yuan’s peg against the dollar.

A broken system for making mortgage-backed securities

Those dollars had to come back to the U.S., and they did at first via Treasury bond purchases and then in mortgage securities backed by the Treasury, either explicitly — Ginnie Mae securities — or implicitly, Fannie Mae and Freddie Mac securities. The resulting lower interest rates juiced-up housing demand and house price growth, emboldened mortgage lenders, and inflated the subprime mortgage bubble.

A bubble from that flood of Chinese cash wasn’t inevitable, but the system for making mortgage securities was broken. Lots of players were involved in turning mortgages into securities: mortgage lenders who made the loans, investment banks that packed the loans and issued the securities, and rating agencies that graded the quality of the securities. No one, including the investors who bought the securities, was responsible for making sure that the system was working properly from beginning to end. With no one at the helm, lots of bad loans and securities were made.

Regulators also seemed to be AWOL. At the time, the thinking at the Federal Reserve, the nation’s top financial regulatory cop, was that self-interested private markets would figure it out. Who was the Fed to decide that housing was a bubble? Besides, if the bubble burst the Fed could respond by lowering interest rates.

Meanwhile, the biggest risks were being taken by financial institutions that weren’t traditional banks and didn’t even come under the purview of the Fed or other federal regulators, including the Office of the Comptroller of the Currency and Federal Deposit Insurance Corporation. Those generally small non-banks were regulated by states, which were under-resourced and out-gunned.

A haphazard response to failing banks

This all made for a doozy of a financial event. What turned it into a cataclysmic financial crisis was the haphazard response by policymakers to failing financial institutions. Investment bank Bear Stearns was the first major institution to go belly-up, and the Treasury and Fed handled it much as they had in the past by finding a strong buyer to pick up the failing institution on the cheap. In this case, the buyer was J.P. Morgan Chase.

Fannie Mae and Freddie Mac, the mortgage behemoths, were next, and this time the government stepped in by wiping out the shareholders in the two institutions, but backing the bond holders. The Lehman Brothers failure was a week later, and all of the shareholders and bondholders in the investment bank were wiped out. At this point, creditors in the nation’s financial institutions no longer knew where the government backstop was, and they ran for the proverbial door. The financial system all but collapsed.

Of course, policymakers eventually got it together. The Fed lowered rates, engaged in quantitative easing and provided liquidity broadly; the FDIC guaranteed bank debt; Treasury implemented the TARP bailout; and the Obama administration provided a massive dose of fiscal stimulus and ushered in sweeping changes to the regulation of the financial system. It worked in stabilizing the financial system and jump-starting the current economic expansion, but not until significant economic and social damage had been done.

This won’t end well

So, where does this leave us? Are we safe from a future financial crisis given the policy response to the last one?

We are definitely safer. The odds of suffering a similarly severe crisis any time soon are low, most importantly because of changes in regulation. Regulators are wary of too-big-to-fail institutions, and now require them to have much more capital, to be more liquid, and to follow more stringent risk management practices such as stress testing. Moreover, the Fed, like most other central banks, now believes in the use of macroprudential tools — additional regulation and oversight — to weigh against developing bubbles.

Policymakers also now have a cookbook for how to resolve failing too-big-to-fail institutions. While the recipe hasn’t been tested yet in real life, there is good reason to believe it will work much better than the ad-hoc approach taken during the financial crisis.

But we aren’t safe. Interest rates remain exceptionally low, this time not because of China, but because global central banks, including the Fed, continue to follow highly accommodative monetary policies. Global investors in search of a higher return are taking a lot more risk, which is evident in high stock price-earnings multiples, narrow credit spreads in the bond market, and thin commercial real estate cap rates.

Risk-taking has also re-appeared in the securitization market, this time in the collateralized loan obligation or CLO market. CLOs are securitized loans to highly leveraged companies. Global investors can’t seem to get enough of them as the market has taken off. To meet the strong demand, lenders are significantly easing their underwriting standards on commercial and industrial loans to companies. Covenants on these leveraged loans — restrictions on borrowers to ensure they can repay — have also deteriorated.

Regulators are undoubtedly nervous; they issued guidance to banks to rein in their leveraged lending a few years ago. However, an increasing amount of the most aggressive lending is being done by private equity, mezzanine debt, and other institutions outside the banking system and regulators’ purview.

This all sounds a bit too familiar. While it is unlikely to end as badly as the financial crisis, it likely won’t end well. And we will be playing another round of the blame game.

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