Economist from Fed Discusses Financial Crisis

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An economist from the Federal Reserve Bank of San Francisco spoke at USF last Monday night on what is known about the housing crisis and what implications it has for the financial system.

Jon Olson explained how lapses in government regulation and mortgage broker fee structures that promoted a ‘more the merrier,’ atmosphere in the home lending industry were partially to blame for the creation of the recent housing bubble and subsequent bust that has led to global financial problems.

Olson described the blame game that is going on as financial institutions, investors, borrowers, and various levels of government all try to cast blame on someone other than themselves for the implosion of the housing market and credit crisis. Olson’s employer has also been heavily criticized for not doing more to prevent the dramatic increase in sub-prime mortgages leading up to the crisis that are now at the heart of the problem and have led to the collapse of major investment banks Lehman Brothers and Bear Sterns and government takeover of insurance giant AIG.

Professor of Economics Hartmut Fischer, whose department sponsored the presentation, was particularly critical of the Fed’s failure to act earlier. Fischer also defended borrowers saying, “They made a rational choice. If their house’s value went up, they would win, if it went down, they would walk away and lose nothing. They made the rational decision.”

However, Olson said that much of the data that he used in his presentation to illustrate the trends that led to the financial crisis was not available until recently. “Hindsight is 20-20,” he said. One of the problems with the mortgage market is that there is not a central clearing house for all the data. Information is fragmented across companies and geographic locations and creating a clear picture was not possible, he said.

Olson said another cause of the crisis was that the structure of the mortgage market grew increasingly complex to the point where many investors did not know exactly who owned what or how they were tied to the risks of borrowers defaulting on their mortgages.

Olson explained how mortgages are pooled into mortgage backed securities, which are classified by risk and re-divided into collateralized debt obligations, which are in turn classified by risk and re-divided into more complex CDOs, and in some cases re-divided into even more complex CDOs. To add to the confusion, investors started buying insurance on CDOs called credit default swaps, which were also pooled into more complex securities. This mind boggling network of investments made interpreting risk very difficult.

Ratings agencies, such as Moody’s, who analyze investments and rate the riskiness of assets, gave many of these CDOs higher ratings than they would have given the individual assets that went into them. “I’m going to perform a bit of a magic trick here,” said Olson as he explained how the ratings agencies rated assets. “I’m going to take a BBB rated security and turn it into a AAA rated security.” Olson explained that while nothing fundamental changed about the risk of the mortgage backed investments, raters were willing to give them higher ratings when they were restructured.

Olson said that ratings agencies are also partially to blame for the financial crisis because they were far too lax in accounting for the risk in MBS and CDOs.

First year graduate student in the M.S. in Financial Analysis program, Sarinda “Pare” Kasemset said that while she had been discussing the financial crisis in depth in her classes, she was hoping to hear more about possible solutions to the crisis than a further analysis of how the economy fell into its current state.

One student asked Olson when the crisis will be over, to which he replied, “I don’t think anybody knows.” However he went on to say that he had spoken to several people in the mortgage industry who predicted the crisis would clear up sometime in the next 6 to 24 months.

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