raised the
Federal funds rate causing an
Inverted yield curve to slow inflation and get prices and
commodity prices down, that usually puts the economy into a
recession.
Recessions While the causes of the bubble and subsequent crash are disputed, the precipitating factor for the Financial Crisis of 2007–2008 was the bursting of the
United States housing bubble and the subsequent
subprime mortgage crisis, which occurred due to a high default rate and resulting foreclosures of
mortgage loans, particularly
adjustable-rate mortgages. Some or all of the following factors contributed to the crisis: • "widespread failures in
financial regulation and supervision", including the Federal Reserve's failure to stem the tide of
toxic assets. • "dramatic failures of
corporate governance and
risk management at many systemically important
financial institutions" including too many financial firms acting recklessly and taking on too much risk. • "a combination of excessive borrowing, risky investments, and lack of transparency" by financial institutions and by households that put the financial system on a collision course with crisis. • ill preparation and inconsistent action by government and key policy makers lacking a full understanding of the financial system they oversaw that "added to the uncertainty and panic". • a "systemic breakdown in accountability and ethics" at all levels. • "collapsing mortgage-lending standards and the mortgage securitization pipeline". • deregulation of '
over-the-counter'
derivatives, especially
credit default swaps. • "the failures of credit rating agencies" to correctly price risk. • "
Wall Street and the Financial Crisis: Anatomy of a Financial Collapse" (known as the Levin–Coburn Report) by the
United States Senate concluded that the crisis was the result of "high risk, complex financial products; undisclosed conflicts of interest; the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street". • The high delinquency and default rates by homeowners, particularly those with subprime credit, led to a rapid devaluation of mortgage-backed securities including bundled loan portfolios, derivatives and credit default swaps. As the value of these assets plummeted, buyers for these securities evaporated and banks who were heavily invested in these assets began to experience a liquidity crisis. •
Securitization, a process in which many mortgages were bundled together and formed into new financial instruments called
mortgage-backed securities, allowed for shifting of risk and lax underwriting standards. These bundles could be sold as (ostensibly) low-risk securities partly because they were often backed by
credit default swap insurance. Because mortgage lenders could pass these mortgages (and the associated risks) on in this way, they could and did adopt loose underwriting criteria. • Lax regulation allowed
predatory lending in the private sector, especially after the federal government overrode anti-predatory state laws in 2004. • The
Community Reinvestment Act (CRA), a 1977 U.S. federal law designed to help low- and moderate-income Americans get mortgage loans required banks to grant mortgages to higher risk families. Granted, in 2009, Federal Reserve economists found that "only a small portion of subprime mortgage originations [related] to the CRA", and that "CRA-related loans appear[ed] to perform comparably to other types of subprime loans". These findings "run counter to the contention that the CRA contributed in any substantive way to the [mortgage crisis]." • Reckless lending by lenders such as Bank of America's
Countrywide Financial unit was increasingly incentivized and even mandated by government regulation. This may have caused
Fannie Mae and
Freddie Mac to lose market share and to respond by lowering their own standards. • Mortgage guarantees by Fannie Mae and Freddie Mac, quasi-government agencies, which purchased many subprime loan securitizations. The implicit guarantee by the U.S. federal government created a
moral hazard and contributed to a glut of risky lending. • Government policies that encouraged home ownership, providing easier access to loans for subprime borrowers; overvaluation of bundled subprime mortgages based on the theory that housing prices would continue to escalate; questionable trading practices on behalf of both buyers and sellers; compensation structures by banks and mortgage originators that prioritize short-term deal flow over long-term value creation; and a lack of adequate capital holdings from banks and insurance companies to back the financial commitments they were making. • The 1999
Gramm-Leach-Bliley Act, which partially repealed the
Glass-Steagall Act, effectively removed the separation between
investment banks and depository banks in the United States and increased speculation on the part of depository banks. •
Credit rating agencies and investors failed to accurately price the
financial risk involved with
mortgage loan-related financial products, and governments did not adjust their regulatory practices to address changes in financial markets. • Variations in the cost of borrowing. •
Fair value accounting was issued as U.S. accounting standard
SFAS 157 in 2006 by the privately run
Financial Accounting Standards Board (FASB)—to which the SEC had delegated the task of establishing financial reporting standards. This required that tradable assets such as
mortgage securities be valued according to their current market value rather than their historic cost or some future expected value. When the market for such securities became volatile and collapsed, the resulting loss of value had a major financial effect upon the institutions holding them even if they had no immediate plans to sell them. • Easy availability of credit in the US, fueled by large inflows of foreign funds after the
1998 Russian financial crisis and
1997 Asian financial crisis of the 1997–1998 period, led to a housing construction boom and facilitated debt-financed consumer spending. As banks began to give out more loans to potential home owners, housing prices began to rise. Lax lending standards and rising real estate prices also contributed to the real estate bubble. Loans of various types (e.g., mortgage, credit card, and auto) were easy to obtain and consumers assumed an unprecedented debt load. • As part of the housing and credit booms, the number of
mortgage-backed securities (MBS) and
collateralized debt obligations (CDO), which derived their value from mortgage payments and housing prices, greatly increased. Such
financial innovation enabled institutions and investors to invest in the U.S. housing market. As housing prices declined, these investors reported significant losses. • Falling prices also resulted in homes worth less than the mortgage loans, providing borrowers with a financial incentive to enter foreclosure. Foreclosure levels were elevated until early 2014. drained significant wealth from consumers, losing up to $4.2
trillion Defaults and losses on other loan types also increased significantly as the crisis expanded from the housing market to other parts of the economy. Total losses were estimated in the trillions of U.S. dollars globally. These losses affected the ability of financial institutions to lend, slowing economic activity. • Some critics contend that government mandates forced banks to extend loans to borrowers previously considered uncreditworthy, leading to increasingly lax underwriting standards and high mortgage approval rates. These, in turn, led to an increase in the number of homebuyers, which drove up housing prices. This appreciation in value led many homeowners to borrow against the equity in their homes as an apparent windfall, leading to over-leveraging.
Subprime lending The relaxing of credit lending standards by investment banks and commercial banks allowed for a significant increase in
subprime lending. Subprime had not become less risky; Wall Street just accepted this higher risk. Due to competition between mortgage lenders for revenue and market share, and when the supply of creditworthy borrowers was limited, mortgage lenders relaxed underwriting standards and originated riskier mortgages to less creditworthy borrowers. In the view of some analysts, the relatively conservative
government-sponsored enterprises (GSEs) policed mortgage originators and maintained relatively high underwriting standards prior to 2003. However, as market power shifted from securitizers to originators, and as intense competition from private securitizers undermined GSE power, mortgage standards declined and risky loans proliferated. The riskiest loans were originated in 2004–2007, the years of the most intense competition between securitizers and the lowest market share for the GSEs. The GSEs eventually relaxed their standards to try to catch up with the private banks. A contrarian view is that
Fannie Mae and
Freddie Mac led the way to relaxed underwriting standards, starting in 1995, by advocating the use of easy-to-qualify automated underwriting and appraisal systems, by designing no-down-payment products issued by lenders, by the promotion of thousands of small mortgage brokers, and by their close relationship to subprime loan aggregators such as
Countrywide. Depending on how "subprime" mortgages are defined, they remained below 10% of all mortgage originations until 2004, when they rose to nearly 20% and remained there through the 2005–2006 peak of the
United States housing bubble.
Role of affordable housing programs The majority report of the
Financial Crisis Inquiry Commission, written by the six Democratic appointees, the minority report, written by three of the four Republican appointees, studies by
Federal Reserve economists, and the work of several independent scholars generally contend that government
affordable housing policy was not the primary cause of the financial crisis. Although they concede that governmental policies had some role in causing the crisis, they contend that GSE loans performed better than loans securitized by private investment banks, and performed better than some loans originated by institutions that held loans in their own portfolios. In his dissent to the majority report of the Financial Crisis Inquiry Commission, conservative
American Enterprise Institute fellow Peter J. Wallison stated his belief that the roots of the financial crisis can be traced directly and primarily to affordable housing policies initiated by the
United States Department of Housing and Urban Development (HUD) in the 1990s and to massive risky loan purchases by government-sponsored entities Fannie Mae and Freddie Mac. Based upon information in the SEC's December 2011 securities fraud case against six former executives of Fannie and Freddie, Peter Wallison and Edward Pinto estimated that, in 2008, Fannie and Freddie held 13 million substandard loans totaling over $2 trillion. In the early and mid-2000s, the
Bush administration called numerous times for investigations into the safety and soundness of the GSEs and their swelling portfolio of subprime mortgages. On September 10, 2003, the
United States House Committee on Financial Services held a hearing, at the urging of the administration, to assess safety and soundness issues and to review a recent report by the
Office of Federal Housing Enterprise Oversight (OFHEO) that had uncovered accounting discrepancies within the two entities. The hearings never resulted in new legislation or formal investigation of Fannie Mae and Freddie Mac, as many of the committee members refused to accept the report and instead rebuked OFHEO for their attempt at regulation. Some, such as Wallison, believe this was an early warning to the systemic risk that the growing market in subprime mortgages posed to the U.S. financial system that went unheeded. A 2000
United States Department of the Treasury study of lending trends for 305 cities from 1993 to 1998 showed that $467 billion of mortgage lending was made by
Community Reinvestment Act (CRA)-covered lenders into low and mid-level income (LMI) borrowers and neighborhoods, representing 10% of all U.S. mortgage lending during the period. The majority of these were prime loans. Sub-prime loans made by CRA-covered institutions constituted a 3% market share of LMI loans in 1998, but in the run-up to the crisis, fully 25% of all subprime lending occurred at CRA-covered institutions and another 25% of subprime loans had some connection with CRA. However, most sub-prime loans were not made to the LMI borrowers targeted by the CRA, especially in the years 2005–2006 leading up to the crisis, nor did it find any evidence that lending under the CRA rules increased delinquency rates or that the CRA indirectly influenced independent mortgage lenders to ramp up sub-prime lending. To other analysts the delay between CRA rule changes in 1995 and the explosion of subprime lending is not surprising, and does not exonerate the CRA. They contend that there were two, connected causes to the crisis: the relaxation of underwriting standards in 1995 and the ultra-low interest rates initiated by the Federal Reserve after the terrorist attack on September 11, 2001. Both causes had to be in place before the crisis could take place. Critics also point out that publicly announced CRA loan commitments were massive, totaling $4.5 trillion in the years between 1994 and 2007. They also argue that the Federal Reserve's classification of CRA loans as "prime" is based on the faulty and self-serving assumption that high-interest-rate loans (3 percentage points over average) equal "subprime" loans. Others have pointed out that there were not enough of these loans made to cause a crisis of this magnitude. In an article in
Portfolio magazine,
Michael Lewis spoke with one trader who noted that "There weren't enough Americans with [bad] credit taking out [bad loans] to satisfy investors' appetite for the end product." Essentially, investment banks and hedge funds used financial innovation to enable large wagers to be made, far beyond the actual value of the underlying mortgage loans, using
derivatives called credit default swaps, collateralized debt obligations and
synthetic CDOs. By March 2011, the FDIC had paid out $9 billion (c. $ in ) to cover losses on bad loans at 165 failed financial institutions. The Congressional Budget Office estimated, in June 2011, that the bailout to Fannie Mae and Freddie Mac exceeds $300 billion (c. $ in ) (calculated by adding the fair value deficits of the entities to the direct bailout funds at the time). Economist
Paul Krugman argued in January 2010 that the simultaneous growth of the residential and commercial real estate pricing bubbles and the global nature of the crisis undermines the case made by those who argue that Fannie Mae, Freddie Mac, CRA, or predatory lending were primary causes of the crisis. In other words, bubbles in both markets developed even though only the residential market was affected by these potential causes. Countering Krugman, Wallison wrote: "It is not true that every bubble—even a large bubble—has the potential to cause a financial crisis when it deflates." Wallison notes that other developed countries had "large bubbles during the 1997–2007 period" but "the losses associated with mortgage delinquencies and defaults when these bubbles deflated were far lower than the losses suffered in the United States when the 1997–2007 [bubble] deflated." According to Wallison, the reason the U.S.
residential housing bubble (as opposed to other types of bubbles) led to financial crisis was that it was supported by a huge number of substandard loans—generally with low or no downpayments. Krugman's contention (that the growth of a commercial real estate bubble indicates that U.S. housing policy was not the cause of the crisis) is challenged by additional analysis. After researching the default of commercial loans during the financial crisis, Xudong An and Anthony B. Sanders reported (in December 2010): "We find limited evidence that substantial deterioration in
CMBS [commercial mortgage-backed securities] loan underwriting occurred prior to the crisis." Other analysts support the contention that the crisis in commercial real estate and related lending took place
after the crisis in residential real estate. Business journalist Kimberly Amadeo reported: "The first signs of decline in residential real estate occurred in 2006. Three years later, commercial real estate started feeling the effects." Denice A. Gierach, a real estate attorney and CPA, wrote:
Growth of the housing bubble resulted in many homeowners refinancing their homes at lower interest rates, or financing consumer spending by taking out
second mortgages secured by the price appreciation. In a
Peabody Award-winning program,
NPR correspondents argued that a "Giant Pool of Money" (represented by $70 trillion in worldwide fixed income investments) sought higher yields than those offered by U.S. Treasury bonds early in the decade. This pool of money had roughly doubled in size from 2000 to 2007, yet the supply of relatively safe, income generating investments had not grown as fast. Investment banks on Wall Street answered this demand with products such as the
mortgage-backed security and the
collateralized debt obligation that were assigned safe
ratings by the
credit rating agencies. In effect, Wall Street connected this pool of money to the mortgage market in the US, with enormous fees accruing to those throughout the mortgage
supply chain, from the mortgage broker selling the loans to small banks that funded the brokers and the large investment banks behind them. By approximately 2003, the supply of mortgages originated at traditional lending standards had been exhausted, and continued strong demand began to drive down lending standards. By September 2008, average U.S. housing prices had declined by over 20% from their mid-2006 peak. As prices declined, borrowers with
adjustable-rate mortgages could not refinance to avoid the higher payments associated with rising interest rates and began to default. During 2007, lenders began foreclosure proceedings on nearly 1.3 million properties, a 79% increase over 2006. This increased to 2.3 million in 2008, an 81% increase vs. 2007. By August 2008, approximately 9% of all U.S. mortgages outstanding were either delinquent or in foreclosure. By September 2009, this had risen to 14.4%. After the bubble burst, Australian economist
John Quiggin wrote: "And, unlike the Great Depression, this crisis was entirely the product of financial markets. There was nothing like the postwar turmoil of the 1920s, the struggles over gold convertibility and reparations, or the
Smoot-Hawley tariff, all of which have shared the blame for the Great Depression." Instead, Quiggin lays the blame for the 2008 near-meltdown on financial markets, on political decisions to lightly regulate them, and on rating agencies which had self-interested incentives to give good ratings.
Easy credit conditions Lower interest rates encouraged borrowing. From 2000 to 2003, the
Federal Reserve lowered the
federal funds rate target from 6.5% to 1.0%. This was done to soften the effects of the collapse of the
dot-com bubble and the
September 11 attacks, as well as to combat a perceived risk of
deflation. As early as 2002, it was apparent that credit was fueling housing instead of business investment as some economists went so far as to advocate that the Fed "needs to create a housing bubble to replace the Nasdaq bubble". Moreover, empirical studies using data from advanced countries show that excessive credit growth contributed greatly to the severity of the crisis. Additional downward pressure on interest rates was created by a growing U.S.
current account deficit, which peaked along with the housing bubble in 2006. Federal Reserve chairman
Ben Bernanke explained how trade deficits required the U.S. to borrow money from abroad, in the process bidding up bond prices and lowering interest rates. Bernanke explained that between 1996 and 2004, the U.S. current account deficit increased by $650 billion, from 1.5% to 5.8% of GDP. Financing these deficits required the country to borrow large sums from abroad, much of it from countries running trade surpluses. These were mainly the emerging economies in Asia and oil-exporting nations. The
balance of payments identity requires that a country (such as the US) running a
current account deficit also have a
capital account (investment) surplus of the same amount. Hence large and growing amounts of foreign funds (capital) flowed into the U.S. to finance its imports. All of this created demand for various types of financial assets, raising the prices of those assets while lowering interest rates. Foreign investors had these funds to lend either because they had very high personal savings rates (as high as 40% in China) or because of high oil prices.
Ben Bernanke referred to this as a "
saving glut". A flood of funds (
capital or
liquidity) reached the U.S. financial markets. Foreign governments supplied funds by purchasing
Treasury bonds and thus avoided much of the direct effect of the crisis. U.S. households used funds borrowed from foreigners to finance consumption or to bid up the prices of housing and financial assets. Financial institutions invested foreign funds in
mortgage-backed securities. The Fed then raised the Fed funds rate significantly between July 2004 and July 2006. This contributed to an increase in one-year and five-year
adjustable-rate mortgage (ARM) rates, making ARM interest rate resets more expensive for homeowners. This may have also contributed to the deflation of the housing bubble, as asset prices generally move inversely to interest rates. It became riskier to speculate in housing. U.S. housing and financial assets dramatically declined in value after the housing bubble burst.
Weak and fraudulent underwriting practices Subprime lending standards declined in the U.S.: in early 2000, a subprime borrower had a FICO score of 660 or less. By 2005, many lenders dropped the required FICO score to 620, making it much easier to qualify for prime loans and making subprime lending a riskier business. Proof of income and assets were de-emphasized. Loans at first required full documentation, then low documentation, then no documentation. One subprime mortgage product that gained wide acceptance was the no income, no job, no asset verification required (NINJA) mortgage. Informally, these loans were aptly referred to as "
liar loans" because they encouraged borrowers to be less than honest in the loan application process. Testimony given to the
Financial Crisis Inquiry Commission by
whistleblower Richard M. Bowen III on events during his tenure as the Business Chief Underwriter for Correspondent Lending in the Consumer Lending Group for
Citigroup, where he was responsible for over 220 professional underwriters, suggests that by 2006 and 2007, the collapse of
mortgage underwriting standards was endemic. His testimony stated that by 2006, 60% of mortgages purchased by
Citigroup from some 1,600 mortgage companies were "defective" (were not underwritten to policy, or did not contain all policy-required documents). This, despite the fact that each of these 1,600 originators was contractually responsible (certified via representations and warrantees) that its mortgage originations met
Citigroup standards. Moreover, during 2007, "defective mortgages (from mortgage originators contractually bound to perform underwriting to
Citi's standards) increased to over 80% of production". In separate testimony to the
Financial Crisis Inquiry Commission, officers of Clayton Holdings, the largest residential loan due diligence and securitization surveillance company in the United States and Europe, testified that Clayton's review of over 900,000 mortgages issued from January 2006 to June 2007 revealed that scarcely 54% of the loans met their originators' underwriting standards. The analysis, conducted on behalf of 23 investment and commercial banks, including 7 "
too big to fail" banks, additionally showed that 28% of the sampled loans did not meet the minimal standards of any issuer. Clayton's analysis further showed that 39% of these loans (i.e. those not meeting
any issuer's minimal underwriting standards) were subsequently securitized and sold to investors.
Predatory lending Predatory lending refers to the practice of unscrupulous lenders enticing borrowers to enter into unfair or abusive secured loans for inappropriate purposes. In June 2008,
Countrywide Financial was sued by then
California Attorney General Jerry Brown for unfair business practices and false advertising, alleging that Countrywide used "deceptive tactics to push homeowners into complicated, risky, and expensive loans so that the company could sell as many loans as possible to third-party investors". In May 2009, Bank of America modified 64,000 Countrywide loans as a result. When housing prices decreased, homeowners in ARMs then had little incentive to pay their monthly payments, since their home equity had disappeared. This caused Countrywide's financial condition to deteriorate, ultimately resulting in a decision by the
Office of Thrift Supervision to seize the lender. One Countrywide employee, who would later plead guilty to two counts of
wire fraud and spent 18 months in prison, stated that, "If you had a pulse, we gave you a loan." Former employees from
Ameriquest, which was the United States' leading wholesale lender, described a system in which they were pushed to falsify mortgage documents and then sell the mortgages to Wall Street banks eager to make fast profits. There is growing evidence that such
mortgage frauds may be a cause of the crisis.
Deregulation and lack of regulation According to Barry Eichengreen, the roots of the financial crisis lay in the deregulation of financial markets. A 2012 OECD study suggested that bank regulation based on the Basel accords encouraged unconventional business practices and contributed to or reinforced the financial crisis. In other cases, laws were changed or enforcement weakened in parts of the financial system. Key examples include: •
Jimmy Carter's
Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA), which phased out several restrictions on banks' financial practices, broadened their lending powers, allowed
credit unions and
savings and loans to offer
checkable deposits, and raised the
deposit insurance limit from $40,000 to $100,000 (thereby potentially lessening depositor scrutiny of lenders' risk management policies). • In October 1982, U.S. President
Ronald Reagan signed into law the
Garn–St. Germain Depository Institutions Act, which provided for
adjustable-rate mortgage loans, began the process of banking deregulation, and contributed to the
savings and loan crisis of the late 1980s/early 1990s. • In November 1999, U.S. President Bill Clinton signed into law the Republican-sponsored
Gramm–Leach–Bliley Act, which repealed provisions of the Glass-Steagall Act that prohibited a
bank holding company from owning other financial companies. The repeal effectively removed the separation that previously existed between Wall Street investment banks and depository banks, providing a government stamp of approval for a universal risk-taking banking model. Investment banks such as Lehman became competitors with commercial banks. Some analysts say that this repeal directly contributed to the severity of the crisis, while others downplay its impact since the institutions that were greatly affected did not fall under the jurisdiction of the act itself. • In 2004, the
U.S. Securities and Exchange Commission relaxed the
net capital rule, which enabled investment banks to substantially increase the level of debt they were taking on, fueling the growth in mortgage-backed securities supporting subprime mortgages. The SEC conceded that self-regulation of investment banks contributed to the crisis. • Financial institutions in the
shadow banking system are not subject to the same regulation as depository banks, allowing them to assume additional debt obligations relative to their financial cushion or capital base. This was despite the
Long-Term Capital Management debacle in 1998, in which a highly leveraged shadow institution failed with systemic implications and was bailed out. • Regulators and accounting standard-setters allowed depository banks like
Citigroup to move significant assets and liabilities off-balance sheet into complex legal entities called
structured investment vehicles, masking the weakness of the capital base of the firm or degree of
leverage or risk taken.
Bloomberg News estimated that the top four U.S. banks will have to return between $500 billion and $1 trillion to their balance sheets during 2009. This increased uncertainty during the crisis regarding the financial position of the major banks. Off-balance sheet entities were also used in the
Enron scandal, which brought down
Enron in 2001. • As early as 1997, Federal Reserve chairman
Alan Greenspan fought to keep the derivatives market unregulated. With the advice of the
Working Group on Financial Markets, the U.S. Congress and President Bill Clinton and the Republican-controlled U.S. Congress allowed the self-regulation of the
over-the-counter derivatives market when they enacted the
Commodity Futures Modernization Act of 2000. Written by Congress with lobbying from the financial industry, it banned the further regulation of the derivatives market. Derivatives such as
credit default swaps (CDS) could be used to hedge or speculate against particular credit risks without necessarily owning the underlying debt instruments. The volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS contracts, as of November 2008, ranging from US$33 to $47 trillion. Total over-the-counter (OTC) derivative
notional value rose to $683 trillion by June 2008.
Warren Buffett famously referred to derivatives as "financial weapons of mass destruction" in early 2003. A 2011 paper suggested that Canada's avoidance of a banking crisis in 2008 (as well as in prior eras) could be attributed to Canada possessing a single, powerful, overarching regulator, while the United States had a weak, crisis-prone and fragmented banking system with multiple competing regulatory bodies.
Increased debt burden or overleveraging relative to disposable income and GDP Prior to the crisis, financial institutions became highly leveraged, increasing their appetite for risky investments and reducing their resilience in case of losses. Much of this leverage was achieved using complex financial instruments such as off-balance sheet securitization and derivatives, which made it difficult for creditors and regulators to monitor and try to reduce financial institution risk levels. U.S. households and financial institutions became increasingly indebted or
overleveraged during the years preceding the crisis. This increased their vulnerability to the collapse of the housing bubble and worsened the ensuing economic downturn. Key statistics include: Free cash used by consumers from home equity extraction doubled from $627 billion in 2001 to $1,428 billion in 2005 as the housing bubble built, a total of nearly $5 trillion over the period, contributing to economic growth worldwide. U.S. home mortgage debt relative to GDP increased from an average of 46% during the 1990s to 73% during 2008, reaching $10.5 trillion (c. $ in ). U.S. household debt as a percentage of annual
disposable personal income was 127% at the end of 2007, versus 77% in 1990. From 2004 to 2007, the top five U.S.
investment banks each significantly increased their financial leverage, which increased their vulnerability to a financial shock. Changes in capital requirements, intended to keep U.S. banks competitive with their European counterparts, allowed lower
risk weightings for AAA-rated securities. The shift from first-loss
tranches to AAA-rated tranches was seen by regulators as a risk reduction that compensated the higher leverage. These five institutions reported over $4.1 trillion in debt for fiscal year 2007, about 30% of U.S. nominal GDP for 2007.
Lehman Brothers went bankrupt and was liquidated,
Bear Stearns and
Merrill Lynch were sold at fire-sale prices, and
Goldman Sachs and
Morgan Stanley became commercial banks, subjecting themselves to more stringent regulation. With the exception of Lehman, these companies required or received government support. Fannie Mae and Freddie Mac, two U.S.
government-sponsored enterprises, owned or guaranteed nearly $5 trillion (c. $ in ) trillion in mortgage obligations at the time they were placed into
conservatorship by the U.S. government in September 2008. These seven entities were highly leveraged and had $9 trillion in debt or guarantee obligations; yet they were not subject to the same regulation as depository banks. Behavior that may be optimal for an individual, such as saving more during adverse economic conditions, can be detrimental if too many individuals pursue the same behavior, as ultimately one person's consumption is another person's income. Too many consumers attempting to save or pay down debt simultaneously is called the
paradox of thrift and can cause or deepen a recession. Economist
Hyman Minsky also described a "paradox of deleveraging" as financial institutions that have too much leverage (debt relative to equity) cannot all de-leverage simultaneously without significant declines in the value of their assets. This boom in innovative financial products went hand in hand with more complexity. It multiplied the number of actors connected to a single mortgage (including mortgage brokers, specialized originators, the securitizers and their due diligence firms, managing agents and trading desks, and finally investors, insurances and providers of repo funding). With increasing distance from the underlying asset these actors relied more and more on indirect information (including FICO scores on creditworthiness, appraisals and due diligence checks by third party organizations, and most importantly the computer models of rating agencies and risk management desks). Instead of spreading risk this provided the ground for fraudulent acts, misjudgments and finally market collapse. Economists have studied the crisis as an instance of
cascades in financial networks, where institutions' instability destabilized other institutions and led to knock-on effects.
Martin Wolf, chief economics commentator at the
Financial Times, wrote in June 2009 that certain financial innovations enabled firms to circumvent regulations, such as off-balance sheet financing that affects the leverage or capital cushion reported by major banks, stating: "an enormous part of what banks did in the early part of this decade—the off-balance-sheet vehicles, the derivatives and the 'shadow banking system' itself—was to find a way round regulation."
Incorrect pricing of risk in the wake of the
AIG bonus payments controversy is interviewed by news media. Mortgage risks were underestimated by almost all institutions in the chain from originator to investor by underweighting the possibility of falling housing prices based on historical trends of the past 50 years. Limitations of default and prepayment models, the heart of pricing models, led to overvaluation of mortgage and asset-backed products and their derivatives by originators, securitizers, broker-dealers, rating-agencies, insurance underwriters and the vast majority of investors (with the exception of certain hedge funds). While financial derivatives and structured products helped partition and shift risk between financial participants, it was the underestimation of falling housing prices and the resultant losses that led to aggregate risk. The
Financial Crisis Inquiry Commission (FCIC) made the major government study of the crisis. It concluded in January 2011: The limitations of a widely used financial model also were not properly understood. This formula assumed that the price of CDS was correlated with and could predict the correct price of mortgage-backed securities. Because it was highly tractable, it rapidly came to be used by a huge percentage of CDO and CDS investors, issuers, and rating agencies.
George Soros commented that "The super-boom got out of hand when the new products became so complicated that the authorities could no longer calculate the risks and started relying on the risk management methods of the banks themselves. Similarly, the rating agencies relied on the information provided by the originators of synthetic products. It was a shocking abdication of responsibility." A
conflict of interest between
investment management professional and
institutional investors, combined with a global glut in investment capital, led to bad investments by asset managers in over-priced credit assets. Professional investment managers generally are compensated based on the volume of client
assets under management. There is, therefore, an incentive for asset managers to expand their assets under management in order to maximize their compensation. As the glut in global investment capital caused the yields on credit assets to decline, asset managers were faced with the choice of either investing in assets where returns did not reflect true credit risk or returning funds to clients. Many asset managers continued to invest client funds in over-priced (under-yielding) investments, to the detriment of their clients, so they could maintain their assets under management. They supported this choice with a "plausible deniability" of the risks associated with subprime-based credit assets because the loss experience with early "vintages" of subprime loans was so low. Despite the dominance of the above formula, there are documented attempts of the financial industry, occurring before the crisis, to address the formula limitations, specifically the lack of dependence dynamics and the poor representation of extreme events. The volume
Credit Correlation: Life After Copulas, published in 2007 by
World Scientific, summarizes a 2006 conference held by Merrill Lynch in London where several practitioners attempted to propose models rectifying some of the copula limitations. See also the article by Donnelly and Embrechts and the book by Brigo, Pallavicini and Torresetti, that reports relevant warnings and research on CDOs appeared in 2006.
Boom and collapse of the shadow banking system There is strong evidence that the riskiest, worst performing mortgages were funded through the "
shadow banking system" and that competition from the
shadow banking system may have pressured more traditional institutions to lower their underwriting standards and originate riskier loans. In a June 2008 speech, President and CEO of the
Federal Reserve Bank of New York Timothy Geithner—who in 2009 became
United States Secretary of the Treasury—placed significant blame for the freezing of credit markets on a
run on the entities in the "parallel" banking system, also called the
shadow banking system. These entities became critical to the credit markets underpinning the financial system, but were not subject to the same regulatory controls. Further, these entities were vulnerable because of
asset–liability mismatch, meaning that they borrowed short-term in liquid markets to purchase long-term, illiquid and risky assets. This meant that disruptions in credit markets would force them to engage in rapid deleveraging, selling their long-term assets at depressed prices. He described the significance of these entities: Economist
Paul Krugman, laureate of the
Nobel Memorial Prize in Economic Sciences, described the run on the shadow banking system as the "core of what happened" to cause the crisis. He referred to this lack of controls as "
malign neglect" and argued that regulation should have been imposed on all banking-like activity. According to the
Brookings Institution, at that time the traditional banking system did not have the capital to close this gap: "It would take a number of years of strong profits to generate sufficient capital to support that additional lending volume." The authors also indicate that some forms of
securitization were "likely to vanish forever, having been an artifact of excessively loose credit conditions". While traditional banks raised their lending standards, it was the collapse of the shadow banking system that was the primary cause of the reduction in funds available for borrowing. Caballero, Farhi, and Gourinchas argued "that the sharp rise in oil prices following the subprime crisis – nearly 100 percent in just a matter of months and on the face of recessionary shocks – was the result of a speculative response to the financial crisis itself, in an attempt to rebuild asset supply. That is, the global economy was subject to one shock with multiple implications rather than to two separate shocks (financial and oil)."
The Globals Savings Glut The cause of the global asset bubble can be partially attributable to the global savings glut. As theorized by
Andrew Metrick, the demand for safe assets following the Asian Financial Crisis coupled with the lack of circulating treasuries created an unmet demand for "risk free" assets. Thus, institutional investors like sovereign wealth funds and pension funds began purchasing synthetic safe assets like Triple-A Mortgage Backed Securities. As a consequence, the demand for so-called safe assets fueled the free flow of capital into housing in the United States. This greatly worsened the crisis as banks and other financial institutions were incentivized to issue more mortgages than before.
Monetary policy Some commentators and economists associated with the
Austrian School of economics, including former
U.S. Congressman Ron Paul and historian
Tom Woods, have offered a
libertarian interpretation of the crisis which differs from the explanations centered on deregulation and government oversight. In Ron Paul's book,
End the Fed, Paul argues that the
Federal Reserve's prolonged policy of
artificially low interest rates in the early 2000s created a
credit bubble that allowed for speculative investments and unsustainable levels of debt, particularly in housing. In Tom Woods' book
Meltdown, he also contends that Federal Reserve manipulation of the money supply and credit markets distorted normal price signals, leading to widespread malinvestment, resulting in an inevitable correction. Paul and Woods also criticized
Fannie Mae's and
Freddie Mac's role in the crisis, asserting that the entities engaged in excessive risk-taking by expanding homeownership beyond sustainable levels.
Systemic crisis of capitalism In a 1998 book,
John McMurtry suggested that a financial crisis is a systemic crisis of
capitalism itself. In his 1978 book,
The Downfall of Capitalism and Communism,
Ravi Batra suggests that growing inequality of
financial capitalism produces speculative bubbles that burst and result in depression and major political changes. He also suggested that a "demand gap" related to differing wage and productivity growth explains deficit and debt dynamics important to stock market developments.
John Bellamy Foster, a political economy analyst and editor of the
Monthly Review, believed that the decrease in GDP growth rates since the early 1970s is due to increasing
market saturation.
Marxian economics followers
Andrew Kliman, Michael Roberts, and Guglielmo Carchedi, in contradistinction to the
Monthly Review school represented by Foster, pointed to capitalism's long-term tendency of the
rate of profit to fall as the underlying cause of crises generally. From this point of view, the problem was the inability of capital to grow or accumulate at sufficient rates through productive investment alone. Low rates of profit in productive sectors led to speculative investment in riskier assets, where there was potential for greater return on investment. The speculative frenzy of the late 1990s and 2000s was, in this view, a consequence of a rising organic composition of capital, expressed through the fall in the rate of profit. According to Michael Roberts, the fall in the rate of profit "eventually triggered the credit crunch of 2007 when credit could no longer support profits". In 2005 book,
The Battle for the Soul of Capitalism,
John C. Bogle wrote that "Corporate America went astray largely because the power of managers went virtually unchecked by our gatekeepers for far too long". Echoing the central thesis of
James Burnham's 1941 seminal book,
The Managerial Revolution, Bogle cites issues, including: • that "manager's capitalism" replaced "owner's capitalism", meaning management runs the firm for its benefit rather than for the shareholders, a variation on the
principal–agent problem; • the burgeoning executive compensation; • the management of earnings, mainly a focus on share price rather than the creation of genuine value; and • the failure of gatekeepers, including auditors, boards of directors, Wall Street analysts, and career politicians. In his book
The Big Mo,
Mark Roeder, a former executive at the Swiss-based
UBS Bank, suggested that large-scale momentum, or
The Big Mo, "played a pivotal role" in the financial crisis. Roeder suggested that "recent technological advances, such as computer-driven trading programs, together with the increasingly interconnected nature of markets, has magnified the momentum effect. This has made the financial sector inherently unstable."
Robert Reich attributed the economic downturn to the stagnation of wages in the United States, particularly those of the hourly workers who comprise 80% of the workforce. This stagnation forced the population to borrow to meet the cost of living. Economists
Ailsa McKay and
Margunn Bjørnholt argued that the financial crisis and the response to it revealed a crisis of ideas in mainstream economics and within the economics profession, and call for a reshaping of both the economy, economic theory and the economics profession.
Wrong banking model: resilience of credit unions A report by the
International Labour Organization concluded that
cooperative banking institutions were less likely to fail than their competitors during the crisis. The cooperative banking sector had 20% market share of the European banking sector, but accounted for only 7% of all the write-downs and losses between the third quarter of 2007 and first quarter of 2011. In 2008, in the U.S., the rate of commercial bank failures was almost triple that of
credit unions, and almost five times the credit union rate in 2010. Credit unions increased their lending to small- and medium-sized businesses while overall lending to those businesses decreased. ==Prediction by economists==