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Believe It or Not: 4 Myths That Spurred the Financial Crisis

Federal Reserve Bank of Boston chief Eric Rosengren outlined in a speech Monday what he sees as four key "myths" that helped precipitate the financial crisis. He defines these as beliefs held by market participants and government regulators in the years leading up the meltdown:

  • A diversified portfolio of U.S. real estate had little risk of falling in value
  • Triple-A rated securities based on mortgages were so well protected by the structure of the securitization that they posed little risk even if real estate prices did fall
  • The evolution of many financial institutions to an "originate to distribute" model of lending and securitization meant there was little risk exposure to declining real estate prices
  • There was little risk of a "run" on organizations like investment banks that relied on short-term, collateralized borrowing
Such ideas were stubbornly persistent. Although real estate in the U.S. and globally had historically experienced many ups and downs, for instance, many so-called experts argued that a domestic housing crash was highly improbable. Even by 2005, when many economists and financial pros were predicting that housing prices were due to fall, hardly anyone took evasive action.

As for the myth that banks could reduce risk by turning home loans into securities, that was based on the belief that firms tended to sell such assets to investors rather than hold them on their balance sheets. Trouble is, financial executives and regulators ignored that mortgage securities were piling up in other parts of the bank, including off-balance sheet vehicles. These structures were supposed to be sealed off from financial institutions. Fearing for their reputation if they suddenly let them collapse, however, banks were in fact on the hook for the billions in mortgage-related losses stuffed into these entities.

All these beliefs -- fables, in retrospect -- fed each other. And obviously bankers and traders (not to mention lawmakers) had strong financial investments to propagate such stories far and wide. Rosengren's defense against the emergence of a new financial mythology? "Stress tests":

Properly done, stress testing should provide valuable information to organizations on key risk drivers. This needs to be more than feeding a handful of macroeconomic assumptions into a model. It requires an understanding of the events that could lead to that macroeconomic outcome, and what other indirect effects might be likely to occur.
No doubt this would help. Regulators should, as he advises, be able to quickly evaluate the health of key financial companies and take action if it becomes clear that a firm is in danger. Same goes for banking execs, who have even clearer reasons for making sure that their firms aren't riddled with hidden risks.

But as Rosengren concedes, even putting banks on a treadmill is unlikely to help much. That's because exposing fundamental beliefs as wrong often requires execs, regulators, investors and other actors in the financial system to challenge the prevailing wisdom. Such willingness to go against the grain is not typically rewarded in companies -- or any organization, for that matter.

Until CEOs and corporate boards are rewarded for debunking myths rather than spreading them, the storytelling will continue.


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