The basic groundwork to the disruption

of credit flows can be traced to the asset price

bubble of the housing price boom. It has
become a cliché to refer to an asset boom as a
mania. The cliché, however, obscures why
ordinary folk become avid buyers of whatever
object has become the target of desire. An
asset boom is propagated by an expansive
monetary policy that lowers interest rates and
induces borrowing beyond prudent bounds to
acquire the asset. The Fed was accommodative
too long from 2001 on and was slow to tighten
monetary policy, delaying tightening until June
2004 and then ending the monthly 25 basis
point increase in August 2006. The rate cuts
that began on August 10, 2007, and escalated
in an unprecedented 75 basis point reduction
on January 22, 2008, was announced at an
unscheduled video conference meeting a week
before a scheduled FOMC meeand ended too
soon. This was the monetary policy setting for
the housing price boom. In the case of the
housing price boom, the government played a
role in stimulating demand for houses by
proselytizing the benefits of home ownership
for the well-being of individuals and families.
Congress was also more than a bit player in
this campaign. Fannie Mae and Freddie Mac
were created as government-sponsored
enterprises. Beginning in 1992 Congress
pushed Fannie Mae and Freddie Mac to
increase their purchases of mortgages going to
low- and moderate- income borrowers. In 1996,
HUD, the department of Housing and Urban
Development, gave Fannie and Freddie an
explicit target: 42 percent of their mortgage
financing had to go to borrowers with incomes
below the median income in their area. The
target increased to 50 percent in 2000 and 52
percent in 2005. For 1996, HUD required that
12 percent of all mortgage purchases by
Fannie and Freddie had to be “special
affordable” loans, typically to borrowers with
incomes less than 60 percent of their area’s
median income. That number was increased to
20 percent in 2000 and 22 percent in 2005. The
2008 goal was to be 28 percent. Between 2000
and 2005 Freddie and Fannie met those goals
every year, and funded hundreds of billions of
dollars worth of loans, many of them subprime
and adjustable-rate loans made to borrowers
who bought houses with less than 10 percent
down. Fannie and Freddie also purchased
hundreds of billions of dollars worth of
subprime securities for their own portfolios to
make money and help satisfy HUD affordable
housing goals. Fannie and Freddie were
important contributors to the demand for
subprime securities. Congress designed Fannie
and Freddie to serve both their investors and
the political class. Demanding that Fannie and
Freddie do more to increase home ownership
among poor people allowed Congress and the
White House to subsidize low-income housing
outside of the budget, at least in the short run.
Unfortunately, that strategy remains at the
heart of the political process, and of
proposedsolutions to this crisis (Roberts 2008).
Fannie and Freddie were active politically,
extending campaign contributions to
legislators.
A second factor that influenced the
emergence of the credit crisis was the adoption
of innovations in investment instruments such
as securitization, derivatives, and auction-rate
securities before markets 20 Cato Journal
became aware of the flaws in the design of
these instruments. The
basic flaw in each of them was the difficulty of
determining their price. Securitization
substituted the “originate to distribute
securities” model of mortgage lending in lieu of
the traditional “originate to hold mortgages”
model. Additional banking innovations, notably
the practices of the derivatives industry, made
mortgage lending problems worse, shifting risk
that is the basic property of derivatives in
directions that became so complex that neither
the designer nor the buyer of these
instruments apparently understood the risks
they imposed and implicated derivative owners
in risky contingencies they did not realize they
were assuming. Derivatives as well as
mortgage-backed securities were difficult to
price, an art that markets haven’t mastered.
The securitization of mortgage loans spread
from the mortgage industry to commercial
paper issuance, student loans, credit card
receivables, and other loan categories. The
design of mortgage-backed securities
collateralized by a pool of mortgages assumed
that the pool would give the securities value.
The pool, however, was an assortment of
mortgages of varying quality. The designers
gave no guidance on how to price the pool.
They claimed that rating agencies would
determine the price of the security. But the
rating agencies had no formula for this task.
They assigned ratings to complex securities as
if they were ordinary corporate bonds and
without examining the individual mortgages in
the pool. Ratings tended to overstate the value
of the securities and were fundamentally
arbitrary. Absent securitization, all the various
peripheral players in the credit market debacle
including the bond insurers, who unwisely
insured securities linked to subprime
mortgages, would
not have been drawn into the subsidiary roles
they exploited. Securities and banking
supervisors knew that packaging of mortgage
loans for resale as securities to investors was a
threat to both investors and mortgage
borrowers, but remained on the sidelines and
made no attempt to halt the processes as they
unfolded and transformed the mortgage
market.
A third factor leading to the emergence
of the credit crisis was the collapse of the
market for some financial instruments. One
particularly important instrument was the
auction rate security, a long-term instrument
for which the interest rate is reset periodically
at auctions. The instrument was introduced in
1984 as an alternative to ldebt for borrowers
who need long-term funding; but serves as a
shortterm security. In 2007 outstanding
auction rate securities amounted to $330
billion. Normally, the periodic auctions give the
bonds the liquidity of a short-term asset that
trades at about par. The main issuers of
auction rate securities have been
municipalities, hospitals, museums, student
loan finance authorities, and closed-end mutual
funds. When an auction fails, there are fewer
bidders than the number of securities to be
sold. When this happens, the securities are
priced at a penalty rate—typically, the state
usury maximum, or a spread over Libor. This
means the investor is unable to redeem his
money and the issuer has to pay a higher rate
to borrow. Failed auctions were rare before the
credit market crisis. The banks that conducted
the auctions would inject their own capital to
prevent an auction failure. From the fall of
2007 on, these banks experienced credit losses
and mortgage writedowns as a result of the
subprime mortgage market collapse, and
became less willing to commit their own money
to keep auctions from failing. By February 2008
fears of such failures led investors to withdraw
funds from the auction rate securities market.
The rate on borrowing costs rose sharply after
failed auctions. The market became chaotic
with different rates resulting for basically
identical auction rate securities. Different
sectors have been distressed by the failure of
the auction rate securities market (Chicago
Fed Letter 2008). The flaw in the design of this
instrument has been revealed by its market
collapse. A funding instrument that appears
long-term to the borrower but short-term to the
lender is an illusion. A funding instrument that
is long-term for one party must be long-term
for the counterparty. The auction rate
securities market is another example of
ingenuity, similar to the brainstorm that
produced securitization. Each seemed to be a
brilliant innovation. Securitization produced
products that were difficult to price. Auction
rate securities could not survive the inherent
falsity of its conception. Both proved disastrous
for credit market operations.

By March 2007, if we see, it appeared

that these hedge fund housing losses could
threaten the economy. Throughout the
summer, banks became unwilling to lend to
each other, afraid that they would receive bad
MBS in return. No one knew how much bad
debt they had on their books, and no one
wanted to admit it. If they did, then their credit
rating would be lowered, their stock price
would fall, and they would be unable to raise
more funds to stay in business. The stock
market see-sawed throughout the summer, as
market-watchers tried to figure out how bad
things were.

By August, credit had become so tight that the

Fed loaned banks $75 billion to restore liquidity
long enough for the banks to write down their
losses and get back to the business of loaning
money. Instead, banks stopped lending to
almost everybody. The vicious cycle was
underway. As banks cut back on mortgages,
housing prices fell further, which caused more
borrowers to go into default, which increased
the bad loans on banks' books, which caused
them to loan less.
Over the next eight months, the Fed lowered
interest rates from 5.75% to 2%, and pumped
billions of dollars into the banking system to
restore liquidity. However, nothing could make
the banks trust each other again. In November
2007, U.S. Treasury Secretary Henry
Paulson realized it was a credibility problem,
not a liquidity problem. He created a
Superfund, using $75 billion in private sector
dollars to purchase bad mortgages which were
then guaranteed by the Treasury. But, by this
time, it was too late as panic gripped the
financial markets, and $75 billion was no
longer enough.
So, two things could have prevented the
crisis. The first would be regulation of
mortgage brokers, who made the bad loans,
and hedge funds, who used too much leverage.
The second would be recognition early-on that
it was a credibility problem, and that the
government would have to buy the bad loans.
If it had been done last year, the bill might
have been less than $700 billion.

However, to some extent, the financial crisis

was caused by financial innovation that
outstripped human intellect. The potential
impact of new products, like MBS and
derivatives, were not understood even by the
quant jocks who created them. Regulation
could have softened by downturn by reducing
some of the leverage, but it couldn't have
prevented the creation of new financial
products, nor would you want it to. To some
extent, fear and greed will always create
bubbles, and innovation will always have an
impact that is not understood until well after
the fact.

Many analysts, academics and government officials have

blamed the compensation plansthat were common on Wall
Street before the financial crisis for encouraging executives
to take unnecessary risks. These plans put a premium on
pursuing short-term profits and increases in stock price. For
now, banking regulators have decided to stick with the
guidance-oriented approach they adopted in June. The
guidance requires that banks ensure that pay plans reward
long-term performance rather than excessive risk-taking;
that banks monitor their risks carefully; and that boards
play a large role monitoring compensation practices. Banks
must submit plans for overhauling their pay programs to
meet the new guidance in coming months, but no deadline
has been specified. Federal regulators considered issuing
more specific rules but concluded it was too difficult to
come up with pay plans that would meet the needs of the
wide range of firms and executives covered, according to
sources familiar with regulators' thinking.

But regulators could change their minds, the sources said,

speaking on condition of anonymity because they were not
authorized to discuss the matter publicly. A number of
leading academics, including Bebchuk, argue that banks
need to tie compensation to a broader range of indicators
than used previously. Historically, a company's stock price
and annual profits have been among the drivers of banker
pay. Academics say these can be good measures for
determining compensation but cannot be used alone. For
starters, they say, pay should be tied to a bank's stock price
and earnings over a three- to five-year period. But in
addition, academics say, bank pay should be tied to more
than stock price and annual profits, because the value
created for shareholders is not all that a bank represents.
The bank has a variety of interests, including bond holders
and the government as the ultimate insurer of deposits. For
this reason, compensation should also be linked, for
instance, to the value of a bank's debt, according to this
view. Alex Edmans and Qi Liu of the University of
Pennsylvania described the thinking behind this approach
in a recent essay:"We start with a model in which the CEO
chooses between a risky and a safe project. . . . A CEO who
holds only equity will take the risky project even when it
destroys value because, if he gets lucky and it pays off, his
equity will soar; but if it fails, it's bondholders who suffer
most of the losses" as in the recent crisis.
The subprime crisis came about in large
part because of financial instruments such as
securitization where banks would pool their
various loans into sellable assets, thus off-
loading risky loans onto others. (For banks,
millions can be made in money-earning loans,
but they are tied up for decades. So they were
turned into securities. The security buyer gets
regular payments from all those mortgages;
the banker off loads the risk. Securitization was
seen as perhaps the greatest financial
innovation in the 20th century.)

As BBC’s former economic editor and

presenter, Evan Davies noted in a
documentary called The City Uncovered with
Evan Davis: Banks and How to Break
Them (January 14, 2008), rating agencies were
paid to rate these products (risking a conflict of
interest) and invariably got good ratings,
encouraging people to take them up.

Starting in Wall Street, others followed

quickly. With soaring profits, all wanted in,
even if it went beyond their area of expertise.
For example,
• Banks borrowed even more money to lend

out so they could create more securitization.

Some banks didn’t need to rely on savers as
much then, as long as they could borrow
from other banks and sell those loans on as
securities; bad loans would be the problem
of whoever bought the securities.
• Some investment banks like Lehman

Brothers got into mortgages, buying them in

order to securitize them and then sell them
on.
• Some banks loaned even more to have an

excuse to securitize those loans.

 • Running out of who to loan to, banks
turned to the poor; the subprime, the riskier
loans. Rising house prices led lenders to
think it wasn’t too risky; bad loans meant
repossessing high-valued property.
Subprime and “self-certified” loans
(sometimes dubbed “liar’s loans”) became
popular, especially in the US.
• Some banks evens started to buy securities

from others.
• Collateralized Debt Obligations, or CDOs, (even more

complex forms of securitization) spread the risk but

were very complicated and often hid the bad loans.
While things were good, no-one wanted bad news.
High street banks got into a form of investment
banking, buying, selling and trading risk. Investment
banks, not content with buying, selling and trading risk,
got into home loans, mortgages, etc without the right
controls and management.

Many banks were taking on huge risks

increasing their exposure to problems. Perhaps
it was ironic, as Evan Davies observed, that a
financial instrument to reduce risk and help
lend more—securities—would backfire so
much.

When people did eventually start to see

problems, confidence fell quickly. Lending
slowed, in some cases ceased for a while and
even now, there is a crisis of confidence. Some
investment banks were sitting on the riskiest
loans that other investors did not want. Assets
were plummeting in value so lenders wanted to
take their money back. But some investment
banks had little in deposits; no secure retail
funding, so some collapsed quickly and
dramatically.

The problem was so large, banks even with

large capital reserves ran out, so they had to
turn to governments for bail out. New capital
was injected into banks to, in effect, allowthem
to lose more money without going bust. That
still wasn’t enough and confidence was not
restored. (Some think it may take years for
confidence to return.) Shrinking banks suck
money out of the economy as they try to build
their capital and are nervous about loaning.
Meanwhile businesses and individuals that rely
on credit find it harder to get. A spiral of
problems result. As Evan Davies described it,
banks had somehow taken what seemed to be
a magic bullet of securitization and fired it on
themselves.

Some institutions were paying for risk on

margin so you didn’t have to lay down the
actual full values in advance, allowing people
to make big profits (and big losses) with little
capital. As Nick Leeson (of the famous Barings
Bank collapse) explained in the same
documentary, each loss resulted in more
betting and more risk taking hoping to recoup
the earlier losses, much like gambling.
Derivatives caused the destruction of that
bank.

Hedge funds have received a lot of criticism for

betting on things going badly. In the recent
crisis they were criticized for shorting on
banks, driving down their prices. Some
countries temporarily banned shorting on
banks. In some regards, hedge funds may have
been signaling an underlying weakness with
banks, which were encouraging borrowing
beyond people’s means. On the other hand the
more it continued the more they could profit.

The market for credit default swaps market (a

derivative on insurance on when a business
defaults), for example, was enormous,
exceeding the entire world economic output of
$50 trillion by summer 2008. It was also poorly
regulated. The world’s largest insurance and
financial services company, AIG alone had
credit default swaps of around $400 billion at
that time. A lot of exposure with little
regulation. Furthermore, many of AIGs credit
default swaps were on mortgages, which of
course went downhill, and so did AIG.
The trade in these swaps created a whole web
of interlinked dependencies; a chain only as
strong as the weakest link. Any problem, such
as risk or actual significant loss could spread
quickly. Hence the eventual bailout (now some
$150bn) of AIG by the US government to
prevent them failing.