The 2008 financial meltdown wasn't due to businesses not applying risk assessment. It was due to crony capitalism.
This is a bit of an oversimplification, but more importantly it arbitrarily picks causation. If I shoot you and that causes you to fall into traffic and get hit by a car, you could argue that you were killed by traffic, but I wouldn't agree that was the reasonable proximate cause. Furthermore, if you were to argue that the cause of death was my acquisition of a gun permit, that would also not really properly fix causation. My decision to shoot you was the proximate cause.
The real estate bubble had a lot of causes, but it wasn't even the proximate cause of the financial crisis. First, I don't buy the argument that the Affiordable Housing Act "forced" banks to lend to non-credit worthy customers. That's just plain false. The banks did not need to be incentivized by the government to lend money because they were already being incentivized by the new markets for mortgage securitization. There exists no law that required banks to reduce their credit requirements, much less totally eliminate them which is basically what they did. They were offering loans with ludicrous terms that defied all financial logic.
But even that didn't spark the financial crisis. If the banks made stupid loans then all that would ordinarily mean was that they would then suffer the losses due to their own stupidity. The real problem was that the banks were not (and these days still often don't) keeping those loans on their own books. They were securitizing them. By creating financial securities that were backed by mortgages they could in effect sell off the risk of those loans. The banks could make a bunch of thirty year mortgages, get paid *today* for all of them, reduce their risk to zero, and then go make more loans.
The people buying those securities would then incur the risk associated with default. But the banks deliberately created security "baskets" that were difficult to analyze the risk for. Difficult because they had all kinds of mortgages in them. The banks argued that by making the securities backed by a blend of all different kinds of mortgages, they became "safer" because the mortgages were not coupled. The risks associated with one were independent of the risks associated with the other. The law of averages would make the security safer than the individual mortgages were.
But even *that* wasn't enough. The people who bought the securities knew perfectly well that there was a chance for them to lose money if those mortgages went south. So they went and bought insurance against default. That's actually illegal: you can't sell that kind of insurance. So the financial community, always an inventive sort**, created a loophole. They created an instrument called a credit default swap, that in effect was insurance: the buyer of the CDS would get paid if their loans were defaulted on.
You now had a system where banks were writing any loans they wanted because they could write loans at zero risk. They were selling off the risk in mortgage backed securities. And the securities community could make an unlimited amount of these with zero risk, because they were completely insured against that risk. The problem was that the insurance companies themselves should have been the final stop against this pyramid. Those credit default swaps were in effect containers of risk. They had, like everyone else, considered only the short term risk of individual defaults. The odds of a single person defaulting was low, and the odds of a huge number of them simultaneously defaulting was therefore even lower, so the odds of having to pay off on a CDS was equally low. But that didn't take into account what would happen if the real estate market dropped. If it did, that could cause a lot of people all over the country to simultaneously default because they were no longer independent events: they were now coupled to the larger real estate market.
What's worse is that a system-wide real estate slump would have other collateral effects: the economy would slow, and that would also increase the risk of default (people would lose their jobs or get pay cuts). The whole thing was built on a pyramid of a financial system that fundamentally abrogated their responsibility to factor in risk. To me, the entire escapade was absolutely the failure of proper risk assessment. Every single link in the chain had a responsibility to account for risk, and every single link in the chain
deliberately ignored that responsibility, because everyone was making too much money to care.
When the crash happened, it happened fast. Bear Sterns went down because for some reason they did not offset a lot of their risk in subprime mortgages: they were the canary in the cage. Lehman was in a similar situation and quickly went down next. But that alone would not have caused the chain reaction that happened next. They were investment banks, and had only a small overall impact on the US and world economy. The problem was that with attention on Bear and Lehman, people began to look a lot more carefully at their mortgage backed securities and CDS instruments. Investors got nervous, and the value of these things began to unravel.
The banks that purchased CDS insurance against default
believed they were risk free because they were insured against risk. But that presumes the insurance companies can pay off. At the time of the financial crisis insurance companies were on the hook for literally
trillions of dollars of potential losses. There wasn't enough money in all the insurance companies in the world to pay off all of them. That's when all that risk everyone just pushed off onto other people came rushing back like a tsunami. If the insurance companies folded, the banks that purchased CDSs could not be made whole and they would fold. The mortgage backed securities themselves would quickly lose a ton of value and then everyone holding them would get wiped out. They would have to start calling in delinquent mortgages at an accelerating rate and then those people would get wiped out.
The real problem with the financial crisis was that there was no way to contain the problem. A problem in mortgages would devour the residential banking industry, the commercial banking industry, the investment banking industry. The housing bubble was a problem, but it wasn't the critical problem. Housing bubbles had come and burst in the past. It was the enormous leverage combined with a total disregard for proper risk analysis and accounting that amplified the problem into a world wide financial disaster.
** In the aftermath of the financial crisis, one of the complaints from the major financial companies was that the government regulations being proposed to prevent a repeat of the problem was causing a "brain drain" in the financial industry. Supposedly smart people were leaving financial services to go work in other industries where they could get paid more. My response was that perhaps the financial industry needed a lot less "financial geniuses" and a lot more people that just knew how to add and subtract and play by the rules without looking to intelligently exploit them. It does not take a genius to do investment banking. It does take a lot of smarts to invent all new ways to play the game. I don't think we need any new ways to play the game.
