The Global Financial Crisis according to Laurence Siegel

Global Financial Crisis Survey

Laurence Siegel is Research Director of the Research Foundation of CFA Institute and a Senior Advisor to Ounavarra Capital. He is a member of the editorial boards of the Financial Analysts Journal, the Journal of Portfolio Management, and the Journal of Investing. His guest editorial in the July/August 2010 issue of The Financial Analysts Journal was titled Black Swan or Black Turkey? The State of Economic Knowledge and the Crash of 20072009 and his edited book Insights into the Global Financial Crisis is a free download with a collection of articles from numerous prominent professionals.

1. Which FCIC View best represents the causes of the Financial Crisis?


None of the views (with a hat tip to Wallison).

2. Which narrative presented by Douglas Elliott and Martin Baily of the Brookings Institute in Telling the Narrative of the Financial Crisis: Not Just a Housing Bubble best represents the causes of the Financial Crisis?


None of these narratives.

3. I believe the crisis is ongoing and I project the Global Financial Crisis will end in the year

2013 or beyond. This does not mean we won't get real economic growth and it doesn't mean we won't get bull markets, but the public debt has to be paid and this will be a drag on growth for a generation, since a greater-than-normal part of what is produced will be diverted to taxes explicit and implicit.

4. What were the primary causes of the Global Financial Crisis?
5. What still should change as a result of the crisis?

There are two crises, almost unrelated. The first was the mortgage-backed securities crisis, caused by (1) the bursting of the housing price bubble and (2) excessive leverage in the housing finance system and excessive spreading of the risk to institutions that were ill-prepared to take that risk. This crisis is over. The second crisis is one of public debt and will not be over until governments are somehow constrained from promising more in benefits than they are able to raise in taxes.

The first crisis is very easy to fix: enforce traditional standards of mortgage underwriting, a 10-20% down payment and a debt-service-to-income ratio around 33%. Exceptions can be made for lenders carrying the loan on their own books

I would note, by the way, that the housing bubble was the problem and the crash was the solution. The prices of houses got to be too high. If an average house in an area sells for 3x average income, people can afford to pay the mortgage; if it is 6x, they can't. Now that housing prices have crashed, the welfare gains to those now entering the housing market are huge. Where I live (Chicago), it is now possible for a 27 or 28 year old professional, 3 or 4 years into his or her career, to buy a passably nice condominium with one year's income. This has not been the case since the late 1970s and, at that time, the low prices were offset by double-digit interest rates. Thus, housing is more affordable than it has ever been (in modern times since accurate records were kept).

As far as those who lost money, Chuck Prince said "While the music is playing, you have to get up and dance." Maybe banks competing to get their share prices up have to dance, but individuals don't, and those who didn't dance in 2007 can dance now (by having cash and cheap assets to buy). I speak as one of those individuals.

Thus the first crisis was a Minsky moment, a short-term - but repeatable - behavioral aberration during which price becomes disconnected from value and the best predictor of future return is past return. This obviously can only continue until a reversal happens and the reversal is much quicker than the original price inflation.

The second crisis, the public debt crisis, is one of too much socialism. Everybody wants at least a little socialism, that is, at least a little government. The problem occurs when the financial commitments made by governments become so large that one generation of legislators is bound by the actions of previous generations and the government loses all flexibility. This has occurred around the world and, at least among the developed countries, the U.S. is one of the least affected. Yet we are seeing signs of a tax revolt here. Instead of voting to raise taxes on themselves to make good on public pension promises or, for that matter, the current compensation of public-sector workers, voters are implying that the government has lost its legitimacy by making entitlement promises that cannot be kept, and are saying "not one more penny."

This problem has been building since the 1960s and demographics made it obvious that it would come to a boil sometime between 2010 and 2020. So there are really no surprises here. However the solutions are extremely unpleasant. Substantial entitlement reform will be required. The whole point of an entitlement is that it cannot be changed and is taken "off the table" in terms of political discussion, so entitlement reform will feel like, and will be, governments reneging on their promises to constituents. Maybe that is why the candidates for president, in both parties, seem like such second-raters - nobody with a clear understanding of the situation wants to govern.

Compiled by Gary Karz, CFA
Host of InvestorHome

Global Financial Crisis Survey

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